# US investment, discounted profits and irrational exuberance

As promised below, I have written something about investment (warning google document)

In the note, I calculate some variables related to discounted future profits. Here is a snip from the paper in which I define them.

Standard micro founded models of investment are based on shareholder value maximization and assume that there are adjustment costs, so investment decisions must be forward looking. They imply high investment when the expected discounted stream of profits per unit of capital is high. If expectations are rational, expected discounted profits should be correlated with actually achieved discounted profits.

The interesting part of the note is just a graph of time series. For this graph I assume depreciation of 1.25% per quarter. I use Moody’s BAA index for the interest rate and look at non residentical fixed capital investment.

prret10 is prret defined in the equation divided by 10. prprfgdp20 is prprfgdp divided by 20.

The pattern is the opposite of that predicted by standard macroeconomic theory — the variables which should be positively correlated are negatively correlated.

In particular, graph shows two episodes of high non residential fixed capital investment and low discounted profits. First there was extremely high investment during the Carter years. Low profits and high interest rates during the Reagan years make this investment seem to have been a mistake. I note in passing that the events which are clearly there in the official data, contradict the generally accepted story about what happened in the US economy back then. Second, as is more widely recognised, there was a huge amount of investment in the late 90s followed by painful disappointment in the 00s.

In any case, the pattern in the data is very clear and is dramatically the opposite of the pattern predicted by standard macroeconomic models.

update:typo corrected.

I’m almost reluctant to post a comment here, because my harping on about the problem of the “general equilibrium” approach are boring. But it seems clear what is happening – a burst of investment increases capacity and so depresses average returns (every firm has a “me-too” product, not all of which can be a hit).

This all sort of makes me wonder what all this talk about “profits” is all about. In a perfectly competitive market there are no profits. So how can a classical (or neo-classical) theory include them?

Please explain the graph clearly so that it can be duplicated.

hmm it appears that my comment was blocked (probably too long)

The raw variables as downloaded from FRED are described in the attached paper. They are

/*”FRED Graph Observations”

“Federal Reserve Economic Data”

“Link: http://research.stlouisfed.org/fred2”

“Help: http://research.stlouisfed.org/fred2/help-faq”

“Economic Research Division”

“Federal Reserve Bank of St. Louis”

PNFI “Private Nonresidential Fixed Investment (PNFI), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

BAA “Moody’s Seasoned Baa Corporate Bond Yield (BAA), Percent, Quarterly, Not Seasonally Adjusted”

GDPC1 “Real Gross Domestic Product (GDPC1), Billions of Chained 2009 Dollars, Quarterly, Seasonally Adjusted Annual Rate”

GDPDEF “Gross Domestic Product: Implicit Price Deflator (GDPDEF), Index 2009=100, Quarterly, Seasonally Adjusted”

GDP “Gross Domestic Product (GDP), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

AAA “Moody’s Seasoned Aaa Corporate Bond Yield (AAA), Percent, Quarterly, Not Seasonally Adjusted”

PRFI “Private Residential Fixed Investment (PRFI), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

GPDI “Gross Private Domestic Investment (GPDI), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

A371RC1Q027SBEA “Private inventories (A371RC1Q027SBEA), Billions of Dollars, Quarterly, Seasonally Adjusted”

A371RX1Q020SBEA “Real private inventories (A371RX1Q020SBEA), Billions of Chained 2009 Dollars, Quarterly, Seasonally Adjusted”

GPDIC96 “Real Gross Private Domestic Investment, 3 decimal (GPDIC96), Billions of Chained 2009 Dollars, Quarterly, Seasonally Adjusted Annual Rate”

“Frequency: Quarterly”

observation_date PNFI BAA GDPC1 GDPDEF GDP AAA PRFI GPDI A371RC1Q027SBEA A371RX1Q020SBEA GPDIC96*/

nrfinv = PNFI “Private Nonresidential Fixed Investment (PNFI), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

GDP = GDP “Gross Domestic Product (GDP), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

nrfinvgdp = nrfinv/gdp

Prret10 = prret/10

prprfgdp20 = prprfgdp/20

prret is calculated according to the equation in the post. Prprfgdp is calculated according to the equation in the post.

The raw variables used are

profits2 = NFCPATAX “Nonfinancial Corporate Business: Profits After Tax (without IVA and CCAdj), Billions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

assets = NCBNATQ027S/1000. NCBNATQ027S = “Nonfinancial corporate business; nonfinancial assets, Level, Millions of Dollars, Quarterly, Seasonally Adjusted Annual Rate”

return = profits2/assets

ibaa = BAA “Moody’s Seasoned Baa Corporate Bond Yield (BAA), Percent, Quarterly, Not Seasonally Adjusted”

delt = 0.0124

finally

gen return = profits2/assets

gen prprf = 1

gen prret = return

scalar ii = 1

scalar delt = 0.0125

scalar num = 24

while ii < num { replace prret = prret + return[_n+ii]/(1 + delt +0.0025*ibaa)^ii replace prprf = prprf + profits2[_n+ii]/(profits2*(1 + delt +0.0025*ibaa)^ii) scalar ii = ii + 1 } gen prprfgdp = prprf*prgdp

Robert:

You have the ability to approve your own comments so they are not blocked.

When working with FRED2, the way to show precisely and easily how a graph is created is to post the link:

Go to “Share” which is under the Fred2 graph and copy the “Link” that has been created. The “Link” created under “Share” when a graph is completed will allow any reader to easily recreate the graph.

http://research.stlouisfed.org/fred2/graph/?g=Uy1

December 15, 2014

Nonresidential investment as a share of Gross Domestic Product, 1947-2014

[ Here for example is the “link” found by clicking “share” which is right below the graph. This “link” describes exactly how I created the graph. ]

http://research.stlouisfed.org/fred2/graph/?g=Uy6

December 15, 2014

Corporate Profits After-Tax as a Share of Gross Domestic Product, 1947-2014

[ Here again for example is the “link” found by clicking “share” which is right below the graph. This “link” describes exactly how I created the graph. I find this post interesting and will be grateful to have the FRED2 link posted, then to recreate the graph. ]

I am grateful for the code you have printed, but I cannot follow it. Please just go to “Share” under your graph and copy and post the “Link” that has been created and I will be able to understand and recreate your graph.

Again, I am grateful.

anne:

Sorry you got locked up in waiting for comment approval.

Anne

I didn’t make the graph at FRED. The calculations are too complicated for FRED. The only ways I can think of to explain how the graph was made are in the paper two which I linked and the STATA do file which I posted in comments.

Reason. In a flexible price DSGE model there are no pure profits. But NFCPATAX “Nonfinancial Corporate Business: Profits After Tax (without IVA and CCAdj)” as defined in the National Income and Product accounts aren’t pure profits — they are returns on equity which can be positive even with perfect competition. Consider a firm which doesn’t borrow or issue bonds or anything. National income and product accounts “profits” would be equal to the marginal product of capital times the firms capital stock.

Also “DSGE” is used to refer to New Keynesian models which have imperfect competition and pure profits as well as to RBC models which have perfect competition.

Again, I am grateful for the explanations and I have read the linked paper carefully. I thought the graph was done with FRED2 however and mistakenly tried to recreate the graph that way. Now I will wade through your careful notes on how the graph presented was made.

In particular, the graph shows two episodes of high non residential fixed capital investment and low discounted profits. First there was extremely high investment during the Carter years. Low profits and high interest rates during the Reagan years make this investment seem to have been a mistake. I note in passing that the events which are clearly there in the official data, contradict the generally accepted story about what happened in the US economy back then. Second, as is more widely recognised, there was a huge amount of investment in the late 90s followed by painful disappointment in the 00s….

[ After I read through the notes you set down, I will try to recreate your graph from this passage on FRED2. I think that should be possible, but may not fully understand what you have done as yet.

No matter my outcome, the paper is excellent. ]