Profits Got Unfrozen

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Posted: Aug 11, 2021 10:00 AM
Profits Got Unfrozen

Source: AP Photo/Elise Amendola

The chart below shows the growth in the entire economy (Gross Output) compared to the growth in the business production side of the economy (Business Output).

(Source: U.S. Bureau of Economic Analysis, as of 6/30/2021 or most recently available)

The business output is focused on the supply chain, whereas the Gross Output includes both supply chain as well as consumer and government spending, and some forms of capital investment.

The three circles in the chart above identify (in order from left to right) the trough during the worst of the COVID crisis; the peak during the recovery; and the period during this year as things returned to something resembling normal. What the peak shows is that business ramped up production faster than the economy recovery, in anticipation of a recovery. This meant a buildup in inventory (which we'll show below). Then as shown inside the circle on the far right, as the consumer returned to consuming, business production seemed to have trouble keeping up.

Let's focus in for a moment on the inventory issue. Below you can see business inventories data:

(Source: St. Louis Federal Reserve, as of May 2021)

This is the ratio of total business inventories to sales from the beginning of 2020 to the latest available data as of this writing (May 2021). We can see that during the worst of the pandemic contraction, the ratio was rising very rapidly. That's not because inventories were rising -- quite to the contrary, they were falling:

(Source: St. Louis Federal Reserve, as of May 2021)

So, if inventories were falling and the inventory to sales ratios were rising, then sales must have been falling more than inventories, which is of course what happened during the worst of the lockdown when sales plummeted.

To get an idea how much of a spike there was in the total business inventories to sales, let's zoom out and look at the entire available history of that measurement:

(Source: St. Louis Federal Reserve, as of May 2021)

One can see looking over towards the right of the chart near the narrow recession band that the spike inventory divided by sales was absolutely unprecedented in this dataset. This represented a huge "bet" by American business that the economy would recover, and that consumers would again consume. It turned out that they were right, and if there was any miscalculation, it was that they underestimated the recovery, which is why the inventory to sales ratio went from the highest on record in April 2020 to the second lowest on record in April 2021. American business went from overstocked and bursting to understocked in one year.

What this meant is that the very low profit numbers in 2020 did not reflect economic reality. Businesses were still creating value and they really ramped up production in the Summer. But the nature of public accounting under GAAP rules is that even though a business creates value when it creates a product which will eventually be sold, it doesn't get to call that value "profit" until the sale actually happens. So, value was "frozen" in the supply chain, waiting for the great thaw when society was allowed to reopen. Then inventories were liquidated, and profits were booked.

You can see that below and now, because of the analysis above, can understand what is really happening:

(Source: U.S. Bureau of Economic Analysis, as of 6/30/2021 or most recently available)

The two circles represent the time when business had its value locked up, unavailable to consumers and then when the value was unlocked and consumers rushed in to restock and return to normal. Which means that a lot of the alleged losses of the pandemic were more like deferral of gains.

But with the ratio of available inventory in comparison to demand for goods and services falling, production is having trouble keeping up with consumption. If inflation is "too much money chasing too few goods," isn't that exactly what we've been seeing? If that were the case, we'd be seeing a lot of inflation. Have we? We'll look at that issue next time.