Are Corporate Profits Actually Very High?

by: Scott Sumner

The OWS crowd is driven by many issues, including income inequality and the falling share of national income going to labor. I have no reason to question the income numbers, but I also think income is meaningless (as it double counts earnings that are saved), what matters is consumption inequality. I do wonder, however, about the profit data. Is it accurate? Robin Hanson pointed to this interesting post by Jialan Wang:

So according to Benford’s law, accounting statements are getting less and less representative of what’s really going on inside of companies. The major reform that was passed after Enron and other major accounting standards barely made a dent.

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Next, I looked at Benford’s law for three industries: finance, information technology, and manufacturing. The finance industry showed a huge surge in the deviation from Benford’s from 1981-82, coincident with two major deregulatory acts that sparked the beginnings of that other big mortgage debacle, the Savings and Loan Crisis. The deviation from Benford’s in the finance industry reached a peak in 1988 and then decreased starting in 1993 at the tail end of the S&L fraud wave, not matching its 1988 level until … 2008.

So the accounting profit data is not accurate. In that case, how would we know if corporations have become highly profitable? The obvious place to look is stock prices. The EMH says equity markets can see though dodgy accounting. In addition, for policy issues related to income distribution we care more about the expected future level of profits over a number of years, rather than merely a snapshot of current profits.

In this post Matt Yglesias shows that stock prices have been very volatile, but in recent years there’s no strong upward trend. Oddly, I think the progressive Matt Yglesias is actually too pessimistic about stock prices–a longer time series would have shown an upward trend.

But are stock prices actually the right metric? After all, stocks measure the discounted present value of future profits. What if the discount rate changes?

We’ve seen real interests rates fall sharply in recent years, to exceptionally low levels. Thus future profits are currently being discounted back into stock prices at a very low discount rate. The fact that the S&P is no higher than in the late 1990s suggests that expected corporate profits have fallen very sharply. (Or has risk aversion increased?)

I also wonder about the problem of multinational investments. Are we interested in corporate profits earned by American firms? Or corporate profits earned using American labor? If it’s the latter, we should add in profits from Japanese transplant factories, and subtract out profits that US MNCs are earning in China. Otherwise you’d end up with anomalies like labor earning less than 1% of national income in the Cayman Islands.

Finance isn’t really my area, so I imagine I’ve made many mistakes here. I await clarification by my many excellent commenters.