Stephen King: Falling profits may not be a good thing for the consumer

Consumers are in danger of having their cake, eating it and then getting indigestion

Is profit a dirty word? A lot of regulators like to think that it might be. Companies that are seen to be earning "abnormal" profits are considered to be exploiting the likes of you and me.

The thinking here is a straightforward reflection of the microeconomic theories that you will find in most introductory economics textbooks. Models of "perfect competition" – where there are lots of competitors and where "barriers to entry" are low – guarantee significant benefits for consumers. Any deviation away from these models – an increase in barriers to entry, a shift towards oligopoly or monopoly – is seen to be a "bad thing". After all, these alternative industry structures tend to imply higher profits as a result of higher prices and lower output. In simple terms, the shareholder wins at the expense of the consumer.

Today, that distinction is increasingly less relevant. Consumers and shareholders can be one and the same thing. As a consumer, the last thing you want is a monopoly that is forcing you to pay more for the product that you want to buy. As a shareholder, you may think that a bit of monopolistic pricing is no bad thing.

The dilemma exposed by this problem is straightforward. The textbooks tend to assume that time does not exist. All that matters is that resources are used in the most efficient way at any point in time. Perfect competition guarantees they are. The existence of monopolies and oligopolies guarantees they are not.

Plonk time into the equation, however, and these conclusions begin to change. The pace of innovation may be influenced by the length of time that high profits can be made. The longer the period of abnormal profit, the greater, perhaps, the chances of risk taking, research and innovation. If this is so, there may be an incentive to allow higher levels of profit relative to those implied by perfect competition to ensure a higher growth rate for an economy over the medium term. The US economy, for example, has enjoyed a particularly high growth rate over the last few decades – at least compared with its peers – partly because the promise of exceptional profits has been left dangling in front of the noses of eager entrepreneurs.

There may also be an argument to suggest that exceptional profits are a key part of the balance between consumption and savings within an economy. Think about Britain's two-tier economy at present. Companies are suffering whereas consumers are spending with abandon. This might suggest that we have seen a shift towards the textbook "perfect competition" model, whereby intense competition drives down prices to levels that benefit the vast majority of consumers at the expense of greedy entrepreneurs.

In this situation, consumers are in danger of having their cake, eating it, getting fat and then getting a bad case of indigestion. Consumers have got used to rising real incomes over the last few years partly as a result of a squeeze on producers. Yet, at the same time, consumers may still be hoping that the tidy little nest egg stored in assorted ISAs will ultimately turn into a plump pension that will keep them happy into their retirement. If there really has been a shift towards perfect competition, they cannot really have both. In this model, rising consumer incomes are only the result of falling producer incomes, implying less capital growth over the medium term.

A good example of this problem comes from this week's charts. In both cases, I'm comparing the performance of the US economy – the level of GDP in current prices – with the cumulative total returns of the US stock market. In the Fifties and early Sixties, shareholders did remarkably well. Returns on the stockmarket massively outstripped returns on the economy. In the late Sixties and in the Seventies, the boot was on the other foot. The economy grew faster than the stockmarket. Now, you might argue that this is an unfair comparison, given that inflation played a big role in boosting GDP in current prices throughout the Seventies. But given that the asset returns also include inflation, this doesn't seem to be a particularly big objection.

Two factors lie behind this radical shift in stock market returns. The first was a slowdown in underlying economic growth. Through the Fifties and the first half of the Sixties, US and global growth were both very strong, leading to strong volume growth for companies. From the second half of the Sixties, this all went a bit wrong. At the same time, the profit share in GDP fell significantly and, like GDP growth, remained at a new, permanently lower, level. A supremely bullish period for shareholders turned into a profoundly bearish period.

In the short term, consumers didn't seem to care. The fall in the profit share simply implied a rise in the wage share. Voters, therefore, remained reasonably content. But, as profits weakened and investment fell back, as returns to shareholders declined and the willingness to take risk slipped back, problems began to spread. The authorities' attempts to keep growth going led to a pick-up in inflation. Meanwhile, companies eventually tried to claw back some of the benefits that had gone to consumers by throwing people out of work. The short-term benefit to consumers ultimately unleashed a long-term dynamic that was unpleasant for virtually all concerned.

This is not to say higher profits are always a good thing. Exploitation, laziness, a failure to serve the consumer properly – these can all stem from a monopolistic position that may – or may not – give rise to excess profits. However, if profits can directly be seen as a reward for enterprise and innovation and if they can be regarded as a reward for staying one step ahead of the competition, they really cannot be seen to be entirely bad.

On this basis, profits can be regarded as a form of social saving. So long as companies use the proceeds to research, innovate and improve their products, profits should contribute to a better rate of economic growth and, hence, a better return for savers. Put another way, when it comes to building your nest egg, far better to invest in a profitable company that offers a decent rate of return. Just ask the Japanese, whose investments in the stock market have come to little after a decade of abysmal profits by their companies.

Stephen King is managing director of economics at HSBC