The Five-Year Fantasy Is Ending

The Five-Year Fantasy Is Ending

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Financial sector profits have been equally wonderful:

Compare those spikes to GDP, which has registered a much more modest increase since 2008.

How could corporate profits have soared on such anemic growth? There are several rarely addressed causes.

1. The weak U.S. dollar greatly increased profits earned overseas when stated in dollars. In 2002, 1 euro of profit earned by a U.S. global corporation equaled $1 in profit when converted to U.S. dollars. That same 1 euro profit swelled to $1.60 a few years ago and still garners $1.37 in profit today. That’s a 37% premium based not on profits being higher but on currency arbitrage.
Given that most U.S. global corporations earn 50% or more of their sales and profits overseas, this is an enormous factor in rising profits.

2. The Federal Reserve’s flood of free money washed over the entire global economy, sparking an orgy of investment and consumption in emerging markets. Some percentage of this flowed to U.S. corporations, which have compensated for weak domestic sales with strong growth in emerging markets.

Both of these conditions are at risk of reversal. The Fed’s modest “tapering” of its liquidity flood triggered a near-collapse in the emerging markets, and the U.S. dollar’s weakness is based on a rising yen and euro. Given the systemic problems in Japan and Europe, this five-year trend could reverse.

Two other factors deserve mention. Some of these corporate profits result from dodgy accounting, not actual net profit. Much of the rise in stocks can be attributed to corporate buy-backs where the companies borrow billions of dollars for next to nothing and then buy back their own shares, driving share prices higher.

In summary, the five-year fantasy that free money would fix all the distortions and systemic problems is drawing to a close. Why can’t the fantasy run forever? The two-word answer: diminishing returns. Handing out subprime auto loans works at first because it pulls demand forward: anyone who wants or needs a new car buys one now, rather than put the purchase off a year or two. Eventually the marginal buyers default and demand falls off, and the distortions cause an even greater collapse in demand and auto loan quality.

This pattern of diminishing return from all the fake fixes can be found in every nook and cranny of the global economy. Papering over structural problems with free money works for a while, but since these monetary/fiscal fixes (distortions) didn’t address the real issues, all they can possibly do is increase the magnitude of the next collapse.

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