April 12, 2001
The jury remains out on whether the current economic stall will be called a recession. So far, weakness has been concentrated, has not been dramatic, and certainly has not persisted long enough to be classified as a recession. Yet, all those conditions could change with more time.
Recession already can be used to describe profits, however. A minor dip in nonfinancial domestic profits occurred during the summer, but legal settlements by the tobacco industry more than justified the minor drop that occurred. Legal settlements were even larger for tobacco in the fall, but the drop in nonfinancial domestic profits would have been more than $50 billion (or more than 6 percent) even without the $14.2 billion settlement reductions in tobacco.
Moreover, the weakness was widespread. Only earnings in banking, chemicals, and from the rest of the world were able to avoid declines. The volatile durable manufacturing registered a 25 percent profit decline from the previous quarter, but declines were apparent even in trade, transportation, and utilities.
Without legal settlements, tobacco profits should rise when the winter results are posted. Banks may continue to make gains while earnings from abroad will continue to rise, but at a much slower pace than the previous quarter. Despite these gains, another 5 percent plunge in nonfinancial domestic profits is almost certain for the winter. Further declines are likely in the spring as well. Indeed, my best guess is that operating profits before taxes probably will decline between 6 and 7 percent for 2001, a far cry from the 10.5 percent profits gains for 2000.
Even if the stock market did not develop a speculative bubble early last year, a decline in values would have been almost certain this year. Stock values almost always decline ahead of profits recessions. (Of course, they rally before the end of the profits decline.)
Three factors appear to be responsible for the weakness in profits. First, excess capacity and international competitiveness have prevented most companies from fully passing cost increases forward to their customers. Second, rising energy prices have pushed up materials costs without providing commensurate gains in the profits of energy providers. (Gains should be apparent in that sector during the first quarter except for some west coast utilities).
Third, productivity gains have vanished. As a result, slowly rising hourly labor costs have begun to dramatically increase the labor costs of production. Without the ability to pass those costs along to consumers, producers have been forced to accept dramatic reductions in their own earnings.
Of course, producers were exceptionally rewarded through much of the previous decade. Much of those gains occurred reflected in higher stock prices, which led to very large capital gains. One of the reasons why personal taxes are at record levels relative to income is because those capital gains generated personal taxes but did not add to personal income.
Indeed, the personal taxes paid per dollar of income probably will fall next year even without a tax cut. This will be because of the drop in capital gains, not the size of any tax cut (which is minimal in the Bush proposals for this year's income).
Why productivity has decided to actually decline in the winter is not well known by economists, but a decline almost certainly is happening.
Inventory accumulations are slowing sharply while capital spending is falling significantly. As a result, the economy probably declined slightly during the winter.
Nevertheless, hours worked grew slightly. This probably occurred because the tightness in labor markets delayed the response of producers to declining orders. They wanted to keep those hard to find workers in case the orders decline was temporary. That is why employment only now is beginning to fall despite signs of economic weakness that were apparent as early as December.
After several months of weakness, however, layoffs have intensified. Industrial production does not appear to be falling as rapidly today as a few months ago. Nevertheless, unemployment claims are the highest in five years. As the labor markets become less strained, employers are more willing to release workers, because they are more certain that talent will be available if orders begin to rebound.
Productivity also is declining because tools are not being upgraded as quickly as they were a year ago. Also, the fluctuations in orders sometimes forces production to deviate from best practices.
Whatever the reason for the productivity slump, there is no question that lower productivity gains are contributing to the slump in profits that is now developing. After a quarter of markedly rising unemployment, productivity gains may again surface. However, the layoffs could undermine consumer confidence, causing further weakness in orders.
Until we can see the end of the profit recession, a general recession cannot be shoved out of the forecasts.