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Spending booms inflate S&P profits
How the books treat spending
On paper, a boom can look healthy because the accounting is doing the work. The companies spending the money do not expense most of it immediately. It is capitalized and depreciated over 5 to 10 years.
The companies on the receiving end, the Nvidias of the world, the Caterpillar tractors of the world, and the utilities, take that money in as revenue and profit immediately.
The mismatch in profits
In a more normalized economy, a dollar would be recognized as revenue by one company and as an expense by another. Here the same dollar contributes to profits to a far greater extent. That mismatch is why S&P profits have taken off in the last 2 years.
The dot-com boom had the same accounting identity problem, and it follows capital spending booms in general.
How does depreciation spread out a cost?
A company that buys equipment records it as an asset and expenses its cost gradually over the asset's useful life. This follows the matching principle, which ties an expense to the period in which the asset helps produce revenue. Under straight-line depreciation, a $10 million machine with a ten-year life produces an expense of $1 million per year.
How did the dot-com boom skew profits?
In the late 1990s, telecommunications companies spent heavily on building fiber-optic networks, and equipment makers such as Cisco and Lucent booked sales and profits from the orders. Cisco's market value passed $500 billion in March 2000. After the crash, much of the fiber sat unused and became known as dark fiber. WorldCom filed for bankruptcy in July 2002, the largest US bankruptcy filing up to that date.
Why do total profits track investment spending?
The Polish economist Michal Kalecki argued in the 1930s that in a simple closed economy, aggregate profits equal what firms invest plus what capitalists consume, minus what workers save. One firm's investment spending becomes income for other firms in the same period, which is why total profits rise when investment rises. Economists later extended the framework to include government and foreign sectors. The relation is known as Kalecki's profit equation.
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