What happened to all the profits?

In the six years ending June, 2014 (a period which encompasses the worst of the 2008 financial crisis and the entirety of the recovery to date), the after-tax profits of U.S. corporations totaled about $8.9 trillion. This marked an all-time record for corporate profits, both nominally and relative to GDP: profits averaged about 9.4% of GDP per year. By comparison, over the past 55 years, after-tax corporate profits have averaged only about 6.4% of GDP per year.

Over the same six-year period, the federal government borrowed about $7.4 trillion from the U.S. and global capital markets to fund its deficit. This resulted in a doubling of the federal debt burden, from 36% of GDP in mid-2008 to about 73% today.

Despite assurances from politicians and most economists of Keynesian persuasion, not only did the biggest and most rapid increase in our federal debt burden since WW II fail to boost the economy, it coincided with the weakest recovery in history—growth of only 2.2% per year on average. (I was among those who warned in late 2008 that this would happen, and quite a few times over the years following.) This is not a problem of not spending enough, it is a failure of ideology, and arguably the most expensive such failure in the history of the world.  

Here's the failure in a nutshell: The government can't stimulate the economy by borrowing from Peter and sending a check to Paul, because that doesn't create any new demand—it's like taking a bucket of water from one end of the pool and pouring it into the other end; the level of the water doesn't change. And the government can't stimulate the economy by spending more, because the government is notoriously inefficient (not to mention the fraud, waste, and incompetence that surround most major public initiatives); the private sector is far more likely to spend its money wisely and productively than the government is. Growth only happens when an economy produces more from a given amount of resources—when productivity rises. And productivity only rises when people work more, smarter, and more efficiently, and that takes hard work and risk. You can't just dial up productivity, you have to work for it. We can't "spend our way to prosperity," as the late and great Jude Wanniski told us.

The past six years in effect have been a laboratory experiment to determine whether Keynesian economic theory is valid. The result? Keynesian economic theory is (or should be) officially dead. It doesn't work. Government can't boost the economy by borrowing or spending more money. Politicians will be unhappy to hear this, of course, since they would prefer that we think they can dispense growth and prosperity on demand. Those who insist in perpetrating this myth should be voted out of office.

Here's my interpretation of what really happened in a nutshell: the private sector generated $8.9 trillion of profits in the past six years, and the federal government borrowed 83% of those profits to fund a massive increase in transfer payments, income redistribution, bailouts, subsidies, and a modest increase in infrastructure spending (as I noted here, only 8% of the 2009 American Recovery and Reinvestment Act went to transportation and infrastructure). Update: we recently learned that $5 billion was spent by the USDA on "questionable or unsupported costs."

What happened to all the profits? Almost all of the most incredible surge in profits in modern times was squandered by our government, flushed down the Keynesian drain.

Now of course many will object to my grossly simplified explanation of what happened. It's true that a good portion of U.S. corporate profits still reside overseas—they haven't been repatriated because companies are loathe to pay the onerous 35% corporate income tax on profits that have already been taxed at their point of origin. But those profits are nevertheless made available to the global capital markets, and money is quite fungible. A trillion dollars of unrepatriated corporate profits can easily find its way back to the U.S., where it can end up being invested in Treasuries owned by a foreign entity. It might just as easily end up being borrowed by companies who want to expand their operations. But no matter how you look at it, corporate profits—wherever they are earned, and wherever they end up—are a source of funds for capital markets, and Treasury borrowings are one way those funds are put to work (or squandered, if you will). It doesn't matter if corporations didn't directly purchase all the bonds that Treasury sold: the net result is that $8.9 trillion of corporate profits were dumped into the capital markets over a six-year period, and the Treasury borrowed $7.4 trillion from those same capital markets over the same period. 

Record profits and record (post-War) government borrowing, all to no avail. 

The following graphs document many of the points made above:

Bailouts and the 2009 ARRA "stimulus" bill resulted in a significant boost to federal spending from mid-2008 to mid-2009. At the same time, the devastating effect of the Great Recession resulted in a predictable collapse of revenues as jobs were lost and profits shrunk. The gap between the red and blue lines was funded by the issuance of about $7.4 trillion of Treasuries.

The true burden of federal borrowing can only be appreciated by comparing how much the government owes relative to the size of the economy, because it's the economy that is the ultimate source of the funds to repay the debt. A $7.4 trillion increase in federal borrowing from mid-2008 to mid-2014 resulted in a record, post-war doubling of the federal debt burden in just six years, from 36% to 73% of GDP.

Despite an unprecedented increase in fiscal "stimulus," the economy has grown at only slightly more than 2% per year on average during the current expansion. This is by far the weakest recovery ever. The conclusion should be obvious: at the very least, fiscal stimulus didn't help, and it's not a stretch to think it actually hurt the economy.

Although this has been the weakest recovery ever, corporate profits have never been stronger. That (the unprecedented sluggishness of the economy despite the unprecedented growth of corporate profits) most likely can be explained by the fact that federal government borrowing consumed almost all of the profits; corporations generated tons of economic resources (i.e., capital) that the government then squandered. When the government commandeers a huge portion of the fruits of the private sector's labor, much money is wasted through inefficiencies, bureaucratic costs, waste, fraud, and the creation of perverse incentives (e.g., taking/borrowing from the most productive members and giving/lending to the least productive). The result is meager growth. 

This is the first recovery in which real growth has not rebounded, within a few years, to its long-term trend. Thus there is arguably a "shortfall" of growth that amounts to $2 trillion dollars or so in lost income each year. We are paying a huge price for this failed experiment in government "stimulus."