Causes of Great Recession

Abstract

Data on 251 quarters of the U.S. economy show that recessions are preceded by declines in profits. Profits stop growing and start falling four or five quarters before a recession. They strongly recover immediately after the recession. Since investment is to a large extent determined by profitability and investment is a major component of demand, the fall in profits leading to a fall in investment, in turn leading to a fall in demand, seems to be a basic mechanism in the causation of recessions.

Causes of Great Recession

Introduction

Profits—the basic variable in business activity—were one of the major concepts analyzed by the founders of political economy, from William Petty to Adam Smith, David Ricardo, and John Stuart Mill. However, profits are quite rarely mentioned in modern discussions in mainstream economics about macroeconomic issues in general or recessions in particular. Even in the heterodox field of progressive or radical economics the 2007-2009 crisis has been seen as related to a number of factors, but not falling profitability. Corporate profits in the U.S. economy, however, had a peak in the third quarter of 2009, well before the upsurge of the serious disturbances in financial markets and the severe downturn of the real economy that were baptized as the Great Recession. As in other recent recessions, profits started decreasing several quarters before the downturn began to be noticeable. This note presents statistical evidence on the fall of profits preceding recessions and discusses the economic meaning of that evidence.

Descriptive Statistics

As a rule, recessions are preceded by a drop in corporate profits. The rate of growth of corporate profits (before or after taxes) starts falling several quarters before the recession, and then becomes negative. This fact is clearly shown by the quarterly data on corporate profits available for the U.S. economy from 2008 to the present. Plotting profits together with the periods of recession (as dated by the National Bureau of Economic Research), the profit curves show peaks a few quarters before the start of each recession (figures 1 and 2).

Figure 1. Recessions (gray rectangles) in the U.S. economy, 1948-1980, according to the NBER chronology, and total corporate profits (before and after taxes, and subdivided for the financial and non-financial sectors).

Centered moving average of 3 quarters, computed from quarterly data seasonally adjusted at annual rate with inventory valuation and capital consumption adjustments. Original NIPA figures (www.bea.gov, Table 1.12. National Income by Type of Income) in current dollars converted to billions of 2005 dollars .

Corporate profits, before and after taxes, and for nonfinancial and financial industries, had a peak in the third quarter of 2009 (Figure 2).

Figure 2. Recessions (gray rectangles) and corporate profits in the U.S. economy, 1980-2010. All specifications as in Figure 1.

Wages and salaries (Figure 3), by contrast, exhibit a quite different behavior. Declining profitability preceding recession is also shown by the share of either corporate profits or the net operating surplus of private enterprises in gross domestic income. Either of these two shares (Figure 4) might be ...