‘Mysterious Divergence’ Between Investment and Profits: A Side Effect of Globalization

By / 7.29.2013

Last week the FT did a long article on the broad divergence between U.S. corporate profits and investment. http://www.ft.com/intl/cms/s/0/8177af34-eb21-11e2-bfdb-00144feabdc0.html#axzz2aKVhUHNE  The author, expressing surprise at the strength of profits compared to the weakness of corporate investment, ran through a long list of potential reasons, included the financial crisis, the information revolution,  short-sighted managers, mismeasurement of intangible investment,  and monopoly power.

Notably missing from the article, though, is any mention of globalization. In fact, the author apologizes in the comments, noting that “Globalisation is another possible factor that I couldn’t manage to fit in.”

But globalization gives the simplest explanation of the “mysterious” divergence. Because of the way that the national statistics are constructed, increased investment in China can produce higher domestic profits in the United States.

How does this work?  Suppose that a large retailer is sourcing a product from an American supplier.  Then a Chinese manufacturer invests $100 million in a Chinese factory to make the same product for half the price(aided by all of the Chinese infrastructure spending ).

When the retailer shifts from the American supplier to the Chinese supplier at the lower price,  the retailer makes some gain in profits, and passes some on to the consumer.  All of those extra profits are booked by economic statisticians as domestic profits.

Ta da! An increase in investment overseas shows up as domestic profits. Imagine the same story multiplied a hundred fold, and that goes a long way to explaining why the divergence is happening in the US.

The larger story, though, is that we have to start thinking globally rather than domestically. I don’t know whether global profits diverge from global investments, but we have to figure in China and other developing countries as well. Second, if we are talking about a fall in the labor share of income, we have to add in rising wages in China as well.

National income accounting is just that—national. And that may give misleading answers in an era of globalization.