Inflation Versus Profits
NOVEMBER 01, 1977 by HENRY HAZLITT
Henry Hazlitt, noted economist, author, editor, reviewer and columnist, is well known to readers of the New York Times, Newsweek, The Freeman, Barron’s, Human Events and many others. Best known of his books are Economics in One Lesson, The Failure of the "New Economics," The Foundations of Morality, and What You Should Know About Inflation.
One of the reasons why inflation is persistently advocated by Keynesians and others is that it is thought to increase the profitability of business. This is, in fact, an essential part of the argument of those who believe that inflation tends to bring "full employment": By improving the outlook for profits, it leads enterprisers to start new businesses or to expand old businesses, and therefore to take on more workers.
As we have seen, inflation may sometimes actually have this effect in its early stages. If it raises final selling prices more than it raises wages and other costs, and if it is expected to be only a temporary condition, it can stimulate increased investment and increased production. But when the inflation continues and is expected to continue, people begin to make compensating adjustments. Wages, interest rates, raw material prices and other costs begin to go up as fast as or faster than final retail prices. Profit margins begin to narrow or to become increasingly uncertain for individual firms. The "stimulus" of inflation becomes a deterrent.
There is an additional factor. Businessmen begin to discover that their monetary profits have been to a certain extent illusory. The dollar profits shown on their income accounts are misleading, because the dollar does not have the purchasing power it previously had.
Economists and statisticians have been aware of this at least ever since index numbers of prices began to be compiled, but it is only in recent years that the accounting profession has acknowledged and attempted to do something to meet the problem.
Accounting reform has been rather piecemeal. It began around 1936. One of the principal practices that falsified financial accounts in an inflationary period was the orthodox method of dealing with inventories. The accountant assumed that the raw materials or parts that were bought earliest were those that were used first and embodied in the final product first. This was called the "first-in first-out" assumption (FIFO). If a part at the time of acquisition cost $1, and at the time of the sale of the finished product cost $2, the manufacturer in effect showed an added profit on his books equivalent to $1 on each of those parts. But this was a "phantom" profit, not likely to be repeated, because when he came to replace that part it would cost him $2.
So accountants are now increasingly advocating the use of the "last-in first-out" method of inventory accounting, popularly known as LIFO. The latest price paid for a particular item of inventory is the price used in making up the account. This means in effect that withdrawals from inventory are priced at the current price paid for additions to inventory. So on the assumption that inventory volume and production rates are relatively constant, LIFO removes part of the "phantom" profit shown by inflation. Even at the time of writing this, however, the firms taking advantage of the LIFO method of inventory accounting are still in a minority.
A second problem to be recognized by accountants is the amount of the write-off that a firm must make every year for the depreciation and obsolescence of its plant and equipment. Here again firms in the past have been grossly overestimating and overstating their profits in an inflationary period by making an insufficient write-off for depreciation.
Let us say that a firm’s plant originally cost it $1 million and its equipment another $1 million, and that it depreciates its plant on a "straight-line" basis over a forty-year period and its equipment over a ten-year period. Then each year, on the average, it will be writing off $25,000 of its plant investment and $100,000 of its equipment investment against its gross earnings. But suppose at the end of the ten-year period it finds that to replace its equipment costs it $2 million, and that at the end of the forty-year period to replace its plant will cost it $16 million (with prices doubling every ten years). Then even at the end of ten years the $125,000 that it has deducted annually will prove to have been grossly inadequate. It may find that it has been paying dividends out of "phantom" profits—i.e., out of capital. At the end of the 40-year period, or much earlier, if may find itself unable to continue in business.
Measuring Replacement Cost
To solve this problem, some accountants are now proposing that depreciation allowances in an inflation no longer be based on original cost of equipment but on replacement cost. This, however, raises other questions. How should the replacement cost be calculated? Should it be the cost of replacing the identical plant or equipment, or the cost of an asset of equivalent operating or productive capability? It is obvious that this calculation is going to involve a lot of subjective guesswork. Still another problem is that in a continuing inflation it is impossible to allow accurately on an annual basis for replacement costs until the year that actual specific replacements have to be made.
Still another accounting problem in an inflation is how to calculate interest charges. Much depends on whether a company is a net lender or a net borrower. If it is a net borrower, it will probably pay during an inflation a higher than normal interest rate for money. On the other hand, it will be paying back its debt in money of depreciated purchasing power as compared with when it was borrowed. It is probable that its "real" gain from this depreciation will be greater than its "real" loss from a higher interest rate.
We come, finally, to "the bottom line." After all allowances have been made to put inventories, depreciation, and other costs on a "real" rather than on a money basis, we come to the amount of net profit. But when we compare this with preceding years we have to remember that the dollars shown in the net profit figure have not the same purchasing power as the dollars shown in the net profit of earlier years.
The ideal of "rational accounting" in an inflation can only be achieved if we can eliminate fluctuations due to changes in the average purchasing power of money and restate everything in terms of dollars of constant purchasing power—all adjusted to some single base year or base period. But this is not easy to do. We will get different results if, for example, in resorting to official calculations, we use the GNP implicit price deflator or the consumer price index to make our adjustments.
Let us put aside pure theory for the moment, and ask what the actual effect has been of using or not using the new inflation-accounting rather than orthodox methods. The difference has not been trivial.
In 1973, the economists of Morgan Guaranty Trust Company calculated that for the second quarter of 1973 "phantom profits" accounted for 40 percent of the total profits reported—$21.1 billion out of a total annual level of $51.9 billion.
In September 1975 George Terborgh presented a table of profits of nonfinancial corporations for each of the eleven calendar years 1964 through 1974, based on Department of Commerce data. Here are his figures for 1974 (in billions of dollars): profits before taxes as reported, $110.1; income tax liability, $45.6; profits after taxes as reported, $64.5; understatement of costs (because of failure to use inflation-accounting), $48.4; profits before tax as adjusted, $61.7; profits after tax as adjusted, $16.1; dividend payments, $26.2; adjusted retained earnings, minus $10.1. In other words, in 1974 these corporations thought they were earning and reported they were earning $64.5 billion after taxes. But they were really earning only $16.1 billion after taxes. And of the $26 billion that they paid out in dividends, more than $10 billion came out of capital.’
Later figures confirm this result. Alcan Aluminium Ltd., with conventional accounting, posted a respectable pretax profit of $96 million for 1976. But required by the Securities and Exchange Commission to assume that its plants and inventories were to be replaced at 1977′s inflated prices, Alcan discovered that its allowance for depreciation soared 140 per cent and its cost of sales edged up 2 per cent. As a result of substituting this replacement-cost accounting, Alcan’s $96 million pretax profit became a hypothetical $119 million loss. This was an extreme case, but some of the profit reductions shown by other large companies were almost as striking.2
Apart from all other difficulties, vested interests stand in the way of "scientific" accounting. Even government agencies are in conflict. On the one hand, the Securities and Exchange Commission wants a company to make adjustments for inflation so as not to give investors an exaggerated idea of its profitability. On the other hand, the Internal Revenue Bureau would like to collect the maximum tax possible, and would like all accounts on an orthodox dollar basis. There is a similar conflict of interest in private business. The owner or stockholders of a company would like it to be on an inflation-accounting basis so as to pay the minimum tax to the government. But the hired managers of the business would like it to show the highest profits as a proof of their good management—not to speak of the fact that many of them receive salary bonuses based on conventionally calculated profits per share.
Putting aside all questions of vested interest, it is increasingly difficult for a corporation to know, during a prolonged period of severe inflation, what it is actually earning. If it keeps conventional accounts, showing costs on an historical dollar basis, it will get false results, and appear to be earning more than it is. But if it attempts to adjust for the rise in prices over time, its adjustments may also be misleading. If, for example, the prices of its specific inventories have gone up more than the average rise in the wholesale or consumers price index, the difference, when those specific inventories have been used up, will represent a "real" profit. And if the managers attempt to allow for quality differences in replaced inventories or plant and equipment, their accounts will again reflect subjective guesswork.3
To emphasize the ambiguity of replacement-cost concepts, the U.S. Steel Corporation, for example, noted that its 1976 replacement cost depreciation would be $600 million under one set of assumptions but would range from $1.1 billion to $1.3 billion under another. Some other companies found that though their replacement cost would be much higher than the historical cost of their plant and equipment, they would be replacing with far more efficient equipment. As a result, industries with rapidly improving technology find their hypothetical profit results much less affected by inflation-accounting than industries with a stagnant technology.4
That corporation managers and investors in an inflationary period will not know precisely how much their companies are earning, is not a matter of merely academic interest. It is chiefly by comparing profitability that men decide what business to go into, or, if they are irrevocably in a given business, in which particular items to increase production and in which to reduce it.
Inflation changes the profitability, or apparent profitability, of different businesses and occupations, and so leads to extensive changes in what is produced. When a major inflation is over, it is discovered that it has led in many cases to increased production of the wrong things at the cost of more necessary things. It leads to malproduction and malinvestment, and hence to huge waste.
But still another effect becomes increasingly serious. Not only do investors and managers not know what their companies are currently earning; they know still less what they are going to earn in the future. In the face of all experience, one of the most persistent of all fallacies is the tacit assumption that in an inflation all prices and wages rise at the same rate. This fallacy is nourished by the monthly publication of official index numbers reducing all wholesale and consumer prices to a single average, and by the persistent practice of newspaper headlines of citing "the" rate of inflation. These government averages of 400 to 2,700 different prices tend to make the man on the street, and even many professional economists, forget that even in normal times all individual prices are constantly changing in relation to each other, and that in periods of severe inflation this diversity and dispersion of price movements becomes far greater.
As we have seen elsewhere, all this leads to increasing business uncertainty. Even if, on the average, inflation tends to increase the total of dollar profits, no individual businessman knows how it is going to affect his own firm. He does not know how much his particular costs—for equipment, raw materials, and labor—are going to rise relative to all other prices in the economy, or whether or not he will be able to raise his own prices correspondingly. This disparity and dispersion of profits among producers increases as the rate of inflation climbs. The increasingly uncertain incidence of profits does far more to discourage new investment than the prospect of an overall increase of profits does to encourage it. A much higher rate of future discount is applied to inflation-generated profits than to those resulting from normal business operations. So employment, production, and investment are not only misdirected by inflation; in the long run they are all discouraged.5
1Capital Goods Review (Washington: Machinery and Allied Products Institute, September 1975.)
2The Wall Street Journal, May 23, 1977.
3George Terborgh has persuasively argued that in converting historical accounting entries into their present-day equivalents it is better both for theoretical and for practical reasons to use only a single index reflecting changes in the general purchasing power of the dollar, and not to attempt to adjust for the specific price rises in items of inventory or equipment. See The Case for the Single-Index Correction of Operating Profit. (Washington: Machinery and Allied Products Institute, 1976.)
4The Wall Street Journal, May 23, 1977.
51n addition to the two papers by George Terborgh cited in the text, the reader interested in pursuing the accounting problem in more detail is referred to Inflation Accounting, by James H. Sadowski and Mark E. Nadolny (The Arthur Andersen Chronicle, January 1977), and Toward Rational Accounting in an Era of Unstable Money, by Solomon Fabricant (New York: National Bureau of Economic Research, Report 16, December 1976). Dr. Fabricant’s discussion is not only excellent in itself, but appends references to some 40 other publications on the subject.