How the bottom line fails to support the goldilocks theory

Diane Coyle on the myth of increased competition
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ONE of the components of today's received wisdom about the economy is that the business environment is more competitive than ever. It has become an even more popular theme in the aftermath of the Asian crisis, with predictions of a "flood" of cheap goods following the devaluation of Asian currencies and collapse of demand in their home markets.

But the notion that competition is fiercer than ever was always one of the building blocks of the "new paradigm" theory that low inflation is now compatible with a higher rate of growth than in previous business cycles. Technological change and improved labour productivity are part of this story, but so too is increased efficiency resulting from globalisation and the consequent increased openness to competition. This is what some economists argue lies behind the shift to a new environment of permanently low inflation.

The new paradigm - also known as the "goldilocks economy" in the US, because growth has blown neither too hot nor too cold - is very enticing. There is almost certainly some truth in it - it is impossible to deny that long-run technological change is altering the way modern economies work. But the fact that this view has become so popular at the point in the US and UK business cycles when growth is passing its peak and a downturn is likely ought to set alarm bells ringing in the sceptical mind.

So to probe the issue, start with the question about how you can tell whether competition has increased. If life is tougher for businesses, it ought to be better for consumers. One indicator of that would be prices. Now, inflation is indeed lower around the industrialised world than it was in earlier decades, with consumer price inflation running in the 0.5 to 3.5 per cent range in most OECD countries (with the UK, surprise, surprise, near the top of the range). Inflation rates further back in the supply chain, at the factory gate, are virtually zero. Retailers are eager to report that if they put up prices, shoppers stay away. And lower inflation has translated into healthy increases in real, inflation-adjusted earnings.

Yet this does not count as conclusive evidence. There are other reasons, apart from increased competition, which explain why observed retail price inflation should be low and stay low. The simplest, and most important, is better macroeconomic policy. Governments have learned from experience and now know how to avoid the kind of policy mistakes that allowed inflation to take off in the past.

In addition, measured consumer price indices mainly measure the price of goods, and some goods have seen dramatic price falls relative to other goods. Any index which includes computers and consumer electronics but excludes other things such as widely purchased services will be reflecting these relative price declines.

This is not a knock-out blow to the increased competition argument, because inflation measured by GDP deflators, the broadest price indices, has also been low. But it does draw attention to the need to keep separate the general argument from the fact that some markets for particular goods are experiencing dramatic technical change or world oversupply or both. Semiconductors, and hence basic computer hardware, and steel both fall into this category.

But looking at prices is a badly flawed method of assessing whether or not businesses are experiencing increased competition. The best indicator is the old bottom line, profits. And that suggests that, actually, companies have never had it so good. For the corporate sector as a whole, the competitive environment is very favourable.

In the UK, for example, the profits of the corporate sector as a whole (not just listed companies) rose by 3 per cent in 1997, following a 10 per cent jump in 1996. Most analysts expect them to grow healthily again this year, although the range of forecasts is wide because of uncertainty about how fast the economy will slow. Last year's profit growth was a shade below GDP growth, so the profit share of national income declined slightly. But, as the graph shows, it remained near its highest level for 30 years.

The corollary of this is that the share of earned incomes in the total has declined over time, and is near its lowest for a generation. This rather torpedoes the theory that the business environment is unusually tough.

The same pattern can be observed around the OECD. The return to capital has increased in almost all countries, meaning that this is the best time to be a capitalist since at least 1970. As brokers ABN Amro point out in their latest quarterly, this fundamental fact is what high stock market valuations have been reflecting. Strategist Gareth Williams still reckons markets are overvalued, with the 20 per cent rise this year down to exuberance - but shame on anybody who thought the markets were being completely irrational.

The profits figures suggest that the new paradigm is shorthand for the fact that gains in labour productivity have been successfully captured rather than frittered away by policy mistakes. Part of the gain has gone in increased real pay, but most of it has increased the profit share. The competitive environment might well have become tougher for some companies or industries, with a struggle over which part of the supply chain captures the increased profits, but certainly not for the business sector as a whole.

Will this pattern continue? Probably not. Apart from the fact that at some point a social reaction will start to improve labour's share of national income once again, diminishing returns to investment are also likely to set in. In both the UK and US, business investment in equipment and plant has been very strong. As the scope for cost-cutting comes to an end - as it must - the returns to additional investment will diminish.

On top of that, the long cyclical upswing will end on both sides of the Atlantic. Businesses will have more to gripe about in future than they have so far. If a company has genuinely been finding competition a bit too stiff in the past five years, with a favourable macroeconomic background and great strides made in profiting from gains in labour productivity, its shareholders should be very worried indeed about how it will cope with the next five.