Monday, October 7, 2013

Think of it this way

Yesterday's graph compared corporate interest cost and corporate profits. Both were down near zero from the late 1940s to around 1970, with profits running a little higher than interest cost. Around 1970 the positions changed. Interest cost went higher than profits.

Both lines climbed gradually, side by side, until the late 1970s. Then suddenly, interest costs separated from profits and went through the roof.

To see how one data series relates to another, it is often useful to show them as a ratio. That creates one line to look at. The pattern traced by that line describes the relation between the two data series. Here, dollars of interest cost per dollar of profit:

Graph #1: Corporate Interest Paid, per Dollar of Corporate Profits
For every dollar of corporate profit in the late 1940s, corporations paid about 15 cents in interest costs. In 1960, half a dollar of interest cost per dollar of profit. And before the 1970 recession, corporations were paying a dollar in interest for each and every dollar of profit they made. A dollar of interest cost, instead of 15 cents.

In the 1970s, despite rising interest rates, corporate interest cost couldn't get upward momentum. Interest costs ran close to profits -- but above profits now, not below, as yesterday's graph showed -- until the late 1970s.

After 1977, everything changed. Corporate interest costs rose rapidly, to twice the level of profits in 1980 and to more than three times profits in 1982, peaking at about $3.30 interest cost per dollar of profit. Then, as interest rates fell, interest costs shot up to a new peak of nearly $4 per dollar of profit. Twice. Thereafter, corporate interest costs came down only reluctantly.

Graph #2: The FedFunds Interest Rate (red) Overlaid on Graph #1
Think of it this way. Suppose the rate of profit is 10%. You buy something for ten bucks. The corporation makes one dollar profit, so we know it had $9 of cost to make the thing you bought.

If this is 1948, 15 cents of the $9 cost is interest cost.

But if this is the mid-1980s, $4 of the $9 is interest cost.

Holy cow!


geerussell said...

Your post made me think about this.

The Arthurian said...

Geerussell, hi. Well I read that SRW link twice now...

Adam smith defined three cost categories
1. what a man makes on his labor
2. what he makes on his accumulated "stock" (or inventory) and
3. what he makes on the land (or by the use of natural resources).

Number 2 he called profit, and number 3 he called rent.

SRW (or economics in general, apparently) calls it profit, economic profit, if a laborer has a job where he makes a good wage. So wages and profits are confused, for starters.

Then he breaks "excess" income down into good and bad, and calls the bad "rent". So now wages and profits and rents are confused.

It's not SRW's fault. But no wonder economists fail to understand the economy. They confuse all the costs!