Profits And Borrowing

I think Marshall Auerback is seriously mixing up different parts of the flow of funds accounts of an economy. He is heteredox, so it will be good if he gets these things right.

In his latest, he asks Why Are US Corporations Borrowing So Much If Profits Are At A Record Percentage Of GDP? (original link no longer works, replaced by alternative), i.e., the reported profits seems contradictory to the fact that borrowing is rising. As mentioned in my recent blog post Massive Overstatement Of Profits?, Auerback attributes it to firms cooking the books. In his latest, he says:

 … debt is once again rising relative to GDP.  That shouldn’t be happening if corporate savings (profits) are booming.

Funnily, his question precisely has the answer: because profits are rising, so has liabilities of U.S. firms, because increased profits has led them to increase investment. This can easily be shown via a few national accounts/flow of funds identities. For the nonfinancial production firms sector, we have:

Net Lending = Undistributed Profits − Investment

Profits is undistributed profits plus dividends, and net lending is net acquisition of financial assets less net incurrence of liabilities,

Net Lending = NAFA − NIL


NIL = Investment − Profits + Dividends + NAFA

where NIL and NAFA are firms’ net incurrence of liabilities and net acquisition of financial assets, respectively in the language of the flow of funds or the system of national accounts such as the 2008 SNA.

This suggests that if profits rise, firms may incur less liabilities but assuming other things in the equation stay the same. But if other things are themselves changing — such as if investment is rising, profits can rise simultaneously with rising liabilities. It is slightly paradoxical at first but CFOs generally know that firms’ borrowing requirement may rise when it is growing fast and the same is possible even if firms are taken as a whole. Firms may also buy back shares by borrowing from banks and this adds more interesting things to the story.

Of course, it is possible that the rising debt may move into an unsustainable territory but this story is a bit different than cooking the books interpretation of Auerback.

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