Profit Margins and the Government’s Deficit

Pretty interesting commentary here from John Hussman’s weekly letter in which he points out that one sector’s deficit is obviously another sector’s surplus.  In the case of the government’s deficits, it’s not surprising that corporations, to a large degree, have been the beneficiaries of the surplus.  After all, when the US government places an order to purchase $50MM in jets from Lockheed Martin who do you think gets to book the profit?  The fact that government deficits can boost corporate profits is not even remotely controversial (although some might actually argue it despite the hard math – the thought of government spending generating profits for private corporations upsets some people – get over it, it happens), but I found Dr. Hussman’s comments pertinent going forward.  He says:

“The deficit of one sector must be the surplus of another.

This is not a theory. It’s actually an accounting identity. But the effect of that identity is beyond question. Elevated corporate profits can be directly traced to the massive government deficit and depressed household savings that we presently observe.

I should note that this result is the outcome of hundreds of millions of individual transactions, so it’s tempting to focus on those transactions as if they are alternate explanations. For example, one might argue that corporate profits are high because people are unemployed, many workers have been outsourced, and government transfer payments are allowing corporations to maintain revenues from consumers despite low wage payments. That’s a perfectly reasonable of saying the same thing – but the transaction detail does not change the basic equilibrium that profits are elevated because government and household savings are dismal. One will not be permanent without the other being permanent.

To see this, notice that corporate profit margins have always moved inversely to the sum of government and household savings.”

That’s a pretty important chart.  What it’s essentially showing is that government deficits have been a big driver of corporate profits.  This won’t come as a surprise to anyone reading this website as I’ve been pointing that out for years, but it’s important to keep in mind going forward as the USA moves to what looks like an increasingly more austere position.  I am not hugely worried about collapsing corporate profit margins at this point because I see private investment recovering AND I still see big budget deficits, but it’s an important risk to keep on the radar….


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Are you hugely worried about the further widening gap between rich and poor? These massive corporate profits are only benefiting a few – and amazingly the goverment (by the people for the people) has bank rolled corporations the whole way through the GFC, with not much left for the household sector. Then again, in the world of financial markets, whose worried about inequality? Or any sort of morality? As Cogan (played by Brad Pitt) says in Killing Me Softly: “America’s not a country, it’s a business. So pay me, mother******!”

  2. I will always maintain that John Hussman is a solid economist but a lousy investment manager. His weekly missives are informative and thought-provoking. His data is interesting despite the fact that he has been calling for a recession for almost two years. And as far as investing is concerned, he has been predicting a market swoon for almost five years now. And his investors have paid the price. His flagship fund is down -14.80% the last four years while the S&P 500 is up 124.44% (Feb 09-Feb 13). That is a bitter pill to swallow. Although his weekly commentaries are interesting, I take them with a grain of salt.

  3. Cullen,

    I continue to read articles (and letters to the editor) in various publications like the WSJ that state “the economy prospered when federal spending fell”. Michael Boskin wrote in an op-ed piece: “the U.S. reduced spending as a share of GDP by 5% from the mid-1980s to mid-1990s. Canada reduced its spending as share of GDP by 8% in the mid-’90s and 2000s. In both cases, the reductions reinforced a period of strong growth.” In a letter to the editor (in the WSJ), a Ronald W. Olive of the Economics department at UMass/Lowell, states that “there is not only an inverse relationship between the federal government’s spending as a share of GDP and economic growth, but the same relationship exists between the federal government’s spending as a share of GDP and the inflation-adjusted or real S&P 500 Index.”

    He goes on to cite other stats about federal spending relative to GDP and the S&P 500 that support his claims.

    Educating Congress and policy makers about MR is challenging, and even more so when “experts” such as Boskin and Olive lay out their findings as noted above.

    From an MR perspective, I believe those in Boskin’s camp are making a mistake by simply looking a federal spending (relative to GDP), rather than considering deficit spending, tax receipts, tax rates, private sector balance sheets, and sectoral balances. Am I on the right track?

  4. Cowpoke,
    Thanks for the link. Wow, Ritholtz didn’t hold back much, did he?

    Still, Boskins will no doubt stand by his stats and ignore all the other stuff that should be considered (such as Greenspan’s actions, deficit spending, etc.). Those in Congress that keep saying we’re going to end up like Greece will continue to stand by those stats too.

  5. Cullen (and everyone else),

    You covered the Kalecki equation and mean reversion to corporate profits extremely well in these three pieces last year:

    These were three of the most informative write-ups on the connection between corporate profits and deficits that I have read in the past two years. I only wish I had been aware of this accounting identity back in 2009. It would have come in handy :)

  6. Corporations have been able to trim their labor forces and cut wages while maintaining sales.
    In the 50m airplane order cited, the deficit spending flows primarily to shareholders and not to workers.
    The idea that government deficits (which consist primarily of entitlements)can be a long-term driver of sectors like auto sales or the home construction industry is unlikely.
    Also long term, deficits create pressure on the private sector to grow in order to avoid inflation pressures created by the debt.
    So I would disagree that this chart proves the deficits are healthy.
    … One interesting thing that the chart shows is that corporations actually had profit margins at the depth of the recession that were in line with historical averages.

  7. There’s definitely some truth in that thinking. For instance, the boom in housing caused the bust. It’s not like consumer balance sheets got all out of whack for no reason which caused private sector investment and spending to collapse. So yeah, you can’t just ignore the cause of the boom when prescribing fixes. But that doesn’t mean govt can’t help us out of a rut or that govt spending is always bad. We have to remember to be a bit more balanced when we’re debating the troubles in aggregate supply and aggregate demand. The Austrians are too far on the aggregate supply side and the Keynesians are always too far on the aggregate demand side. The real answer is likely somewhere inbetween.

  8. Yeah, it’s always the same story from these guys: They never mention the US after WWII, Japan, or how austerity is playing in Europe right now. Nor do they mention FDR trying to balance the budget prematurely in the 1930s.

    Are there other good examples I should be thinking of? I agree that they may have a point, but the way he paints it is “poor businesses were misled by the actions of the Fed.” I thought these entrepreneurs (if anyone!) should be the closest the the “rational actor” that neo-liberals and neo-classicals are so enamored of when modeling the economy. If these guys are so rational and clairvoyant how were they “fooled” so easily by the Fed?

    It’s funny how it’s total dedication to pre-determined ideas… the opposite of “reason” as that web-site is named. What about evidence based policy? I’m not saying I have the answers (because I certainly don’t!), but the message is always loud and clear and certain from people who’ve already made up their minds.

  9. Johnny,
    I know about layoffs in various industries, but wage cuts? Please cite some examples. Perhaps you mean a lack of wage increases/raises along with increased health insurance costs. Still, I think many workers that remained employed (especially with the same company) throughout this recession have seen stable compensation. Also, in many cases the workers are significant shareholders too.

  10. Yes, “Reason” magazine is consistently libertarian. They like free markets, free minds, and promote ideas about much, much, less government in our lives. I’ve posted on their site and suggested they learn more about the operational realities of our monetary system (including links to Cullen’s work). They’ve never responded, so I guess you’re right about their minds being made. At least the Barron’s editor emailed me and said he would read Cullen’s “Understanding The Modern Monetary System”. He even agreed that the federal government can’t run out of money (but rightly expressed concerns about inflation and societal change).

  11. I like to think of myself as a skeptic (James Randi is one of my heroes) in most circumstances, even though I know myself well enough to realize that I’m unskeptical for too often. Was it Einstein who said that “the easiest person to fool is yourself?”

    It’s funny to me that many other self-described “skeptics” are libertarians. I guess you could say that’s being skeptical of government involvement (a good thing!), however, it also sometimes seems to require an unskeptical view of the benefits of small government, private ownership and enterprise, and minimal government action… in ALL CIRCUMSTANCES! That’s what gets me! They always seem to be writing/saying: “How can I explain this new evidence from the point of view that anything beyond the most minimal government is always bad?” … and then, amazingly enough, they DO find a way! I guess I’m highly skeptical of the “libertarian apologist” viewpoint.

    I can see trying out an idea like libertarianism by attempting to use it to explain EVERYTHING… as an intellectual exercise. A way to toy with an idea to deepen your understanding and perhaps find its limitations. But that’s a far cry from ACTUALLY BELIEVING that you know, ahead of time, what your conclusion MUST be when examining ANY new evidence!

    I think that testing our current “best theories” against the evidence should be a big part of continuously tuning our theories to more closely match reality.

    I think it’s great that you’ve tried to engage with them. I’ve done the same in other forums.. with some limited success. What if you were to ask them “What evidence would lead you to conclude that libertarianism is wrong?” How do you think they’d answer that? If their answer is “That’s a ridiculous question, because it’s self evident that no such evidence could possibly exist” … then they’re cultists! Run for your life!

  12. Remember, our economy would fail without government spending…

    Why does not Herr Hussman examine long term GNP growth rates and the expansion of the government spending ?

  13. The auto industry has seen dramatic wage cuts. Ford and GM are hiring again, but at $12 an hour instead of $25, and without pensions. That has caused ripples all down the auto supply chain.

  14. In the example I cited below, it is true that the 50-year-old auto worker has not seen a cut in pay, but the incoming 25-year-old auto worker is brought in at a lower wage.
    So if you are studying the wrong set of workers, it may seem that wages are not falling.

  15. Indeed, Johnny Evers. Although wage depression is still rare with respect to a particular worker at a particular firm (in general workers would rather walk out of a job and then take lower pay elsewhere than suffer the indignity of accepting lower wages for their same job at the same firm), there’s no arguing with your points here. Someone I know was laid off from his job and then was quickly hired by a similar firm doing similar work–at nearly 40% less pay.