Economic Profits vs. Accounting Profits

I don't mean to pick on James Kwak over at Baseline Scenario because I do generally enjoy the blog, but a piece of a post he wrote today reminded me of an elementary mistake many people make that is worth pointing out.

Criticizing a piece in today's Washington Post written by a Yale Law professor, Kwak says:

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost.

But Kwak fails to draw the distinction that he is talking about a different type of profit than the professor is talking about.

The professor is referring to accounting profits. This is what a company reports to the public in the form of net income at the end of a quarter or year (corporate earnings, as the professor calls them). Quite simply, it is the company's total revenues, or sales, minus its expenses, which include the cost of labor, supplies, shipping, buildings, etc. It's what accountants get paid to figure out.

Kwak confuses things, though, because he is referring to economic profits. This is what an economic professor is talking about when he teaches you Econ 101. This includes "costs" an accountant would not consider when reporting net income, mainly opportunity costs. An opportunity cost, as Wikipedia nicely sums up, is the "value of the next best alternative forgone as the result of making a decision."* Economic profits -- not accounting profits -- go to 0 in a perfect economy because companies will continue to enter a market until the benefits of entering market B (in other words, the opportunity cost to entering market A) outweigh the benefits of entering market A. The cost of having to choose to enter market A instead of entering market B, though, is not an expense as an accountant would think of things, so you can easily have an accounting profit in a perfectly competitive market where economic profits are, in fact, equal to zero.

This doesn't necessarily mean Kwak's main argument is wrong, but it is a mistake worth mentioning (which is why I pointed it out in the comments of the post, too). Hopefully this post will keep you from making the same mistake in the future.


* For instance, let's say you take a job with company A for $50,000 over a job with company B for $45,000. The opportunity cost of taking the job is $45,000.

Why Financial Journalism Has Struck Out

The Atlantic’s Derek Thompson wrote an interesting post today critiquing the problems of financial journalism by comparing it to political journalism:

“Politics, I think, is fundamentally different than economics because...well, I don't want to say "because it's just just simpler," even if I suspect it might be the case. Instead I'll say this: Much of economics has its own language. For many Americans, it's a foreign language. Financial regulation reforms, like assessing risk in shadow banking markets, is still, I'm unembarrassed to say, a bit shadowy to me. And the right way to do stimulus spending in a crisis is still shadowy for the economic industry, even though they've been studying it for 60 years!

On the other hand, you don't need to exotically expand your civic vocabulary to understand that American politics is about votes, interests and values, and when you stir them together, you get a stew called strategy. Everybody gets politics, because it's all so much like life. If you were tasked with describing politics exclusively through sports metaphors, I think you could do it pretty effectively. The Democrats struggling to write a passable health care bill to get conservative Democratic support? Kinda like a coach designing a playbook for a quarterback with compromised skills. Obama pledging openness rather than clenched fists to troubling foreign leaders isn't so different from a team's strategy of dealing with troubled players (Artest, Owens, Sprewell) through inclusion rather than punishment. On the other hand, after 10 months, I still can't conjure baseball metaphors for the Public-Private Investment Partnership.”

So does financial journalism simply need more metaphors? Not necessarily. But if economics is going to be as approachable as politics, we're going to have to get creative. We can start by speaking in English, as Felix Salmon wrote, rather than Wall Street acronyms. We can start by imagining our audience, not as the author of the blog post we're responding to, but as the readers of the blog post we're writing, who don't know a CDS from an STD, because we haven't fully explained it since an entry we wrote in March. But we can do it. We can be readable!

I’m actually surprised Thompson considers journalists using sports metaphors to describe politics as an example of successful coverage. I think many people would argue that coverage like that is one of the biggest problems with political journalism. It doesn’t make it more “approachable”—it just fails to adequately discuss the real issues behind legislation. We don’t get to read about the various economic advantages and drawbacks of various health care plans floated by Congress, for instance, but only about which bills can get passed. I’d hate for finance journalism to be more like that.

The mainstream media already tries to shoehorn its business and finance coverage within that structure. Reporters write profiles glorifying (or villifying) CEOs — just like they might write about politicians. They report about company X’s decision to introduce a product to battle with company Y or combat broader trend Z—just like they might write about the fight over a bill. But it’s more difficult to write an explanatory piece about a complex financial instrument—just like it’s difficult to write about the substance of various bills. Journalists need elements like conflict, plot, and characters that that don't necessarily help explain those sorts of things.

The problem is not that readers can’t understand finance (or politics) if you aren’t able to easily compare it to life, sports, or some other thing the “common man” can grasp. The problem is that journalists can’t write about it within their traditional narratives without using those sorts of metaphors. It’s not just about finding the proper language to describe collateralized debt obligations of asset-backed securities, credit default swaps and other complex financial topics in terms readers can comprehend. It’s about finding organizations and structures of stories to convey that knowledge—and I’m not sure they exist in the traditional journalist’s toolbox.

This is why blogs have been so successful in explaining the financial crisis to us. They don’t need to use the inverted pyramid structure or write killer ledes and nutgrafs — they can simply explain collaterlized debt obligations of asset-backed securities to us. Or they can use cool graphics. It’s a bit easier to get something like that on a blog than it is to get it on the front page of the New York Times.

Guess the Center for American Progress Pays Pretty Well

In Matt Ygelsias’s post on Google Chrome OS today, he asks why there is so much interest in netbooks:

I have to say that I’ve never totally understood the appeal of the netbook concept. The low cost is nice, but you can’t use it as your main “go to” computer. So if you have to buy another computer anyway, you may as well invest in a decent laptop. It’s not as if my 13 inch MacBook Pro is so crippling heavy I can’t take it around with me. And I get around town by walking/biking—what does America’s car-dependent majority need with an ultra-light computer?

As Ygelsias himself notes, the problem with regular notebooks is not their size—it’s their cost. The 13-inch MacBook Pro would cost you $1199.99. Compare that to the $325 Asus eee 1000HA, and you can see the appeal.

Despite Ygelias’s contention, there is no reason you couldn’t use a netbook as your “go to” computer. Most people waste money by purchasing computers with more power than they’ll ever use. If you’re doing high-end video editing*, sure, it’s probably worth it to pay extra for an Apple. If you’re just doing word processing, browsing the internet, and listening to music, a netbook will do just fine.

And if Ygelsias is really concerned about power, he should welcome Google OS given that its entire purpose is to advance cloud computing, which could help make netbooks as useful as any other computer. No longer will you rely on your own hardware to complete tasks—you can instead use the internet to access a remote server far more powerful than any computer you’ll ever own**. There’s almost no need to buy Microsoft Word when you can use Google Docs for free.

Google OS aims to make this as easy as possible by booting up your computer and connecting you to the Internet — and thus your applications — as quickly as possible. You’ll have the ability to access your files anywhere***, won't have to worry about software being compatible with your computer’s hardware, and benefit from the lack of bloat on your own computer. And, of course, you’ll save yourself a lot of money. Makes sense to me.


* Or really must look cool.
** Mark Thoma points out this is like returning to the early days of mainframe computers.
*** Obviously, there are drawbacks to this, such as you probably don’t want to rely on Google to store all your personal documents. But for most files, this will probably work.

Who Was Buying It?

In a recent Twitter debate with Felix Salmon regarding Matt Taibbi’s scathing Rolling Stone article on Goldman Sachs, financial reporter Heidi Moore raised an interesting point: investment banks and others could not have created many of the structured finance products that have played a key role in the current crisis if there was no demand for them. So it’s worth examining not just the sell-side of the market, but the buy-side, too.

Personally, I don’t know enough about the specifics of the CDO ABS market to speak authoritatively on who was buying these products and why (and I doubt you want to hear about them).* However, I think we can look at the problem more generally to determine why seemingly sophisticated institutional investors time-and-time again get suckered into buying into the latest fad the investment banks are peddling, whether it be Internet IPOs, mortgage-backed securities, or whatever else they’ll cook up next.

*Although if you do, Yves Smith over at nakedcapitalism.com had a great conversation with a commenter that explores this issue.

I have three theories:

1.) Forgetting the SALES in Salesman – People tend to think they’re getting unbiased advice when it comes from financial-services professionals. That nice mortgage broker really wants to help you afford a new home. The Merrill Lynch man suggests you buy a certain stock to start stashing away for your son’s college fund. Unfortunately, you can no more rely on the people on the sell-side of the market for help than you would your average car-dealer.

The job of people on the sell-side of the market is, not surprisingly, to sell. The mortgage broker really wants to sell you a mortgage not to help you get that house but to make his own commission. Same thing with the Merrill Lynch broker. When it comes to the salesman selling to institutional investors it’s no different. Michael Lewis chronicled in Liar's Poker the art of "blowing up a customer." One player in a story Lewis wrote for Portfolio remarked how he would always ask salesmen from the investment bank: “I appreciate this, but I just want to know one thing: How are you going to screw me?”. Come to think of it, I might prefer the used-car salesman.

Most people would probably be surprised to learn investment banks don’t really have any fiduciary duties. When they’re underwriting a deal, they don’t have a responsibility to get the best deal for the client coming to market with stocks or bonds. When they’re selling those stocks or bonds, they don’t have any obligation to the investor to make sure the product they're selling is worth the investment. It’s a wonder why anyone keeps believing them.

2.) Let's Make a Deal – I also suspect that some institutional investors often invest in certain deals expecting to get a deal on another. The investment banking salesman and the institutional investors are engaged in repeated interactions**. If an institutional investor participates in one deal he's not so certain about, I’m sure salesman offers to get the investor a big discount on another deal.

** Which you think would deter the activity in Theory 1, but it clearly does not.

3.) But Mom… - Finally, I suspect many institutional investors buy these product because of the everyone-else-is-doing-it philosophy. On one hand, you might say this is simply stupid. But from an individual perspective, it may make some sense.

Institutional investors are judged based on how they do compared to other institutional investors. Sure, manager X may think the market is overvaluing Internet stocks, for instance, but if he doesn’t invest in them he will find himself falling behind ever other manager that is investing in them. With returns consistently lagging the market, he will likely see investors pull their money out of his fund. Consequently, he may lose his job before the market crashes and he’s proven right.

Alternatively, manager X might suck it up and just invest in the overpriced Internet stocks. When he is right and the market crashes, he fund loses — but so does every other competing fund. He doesn’t look any worse than any other manager that “didn’t see it coming” and hangs onto his job. It's OK to fail as long as everyone else does to.

Anyway, that's not meant to be a definitive list. Just some ideas kicking around in my head. Take it for what it's worth.

Let's Not Forget

Matt Yglesias writes today about a Washington Op-Ed regarding the budget crisis in California. Yglesias makes an important point:

Even the whole “green shoots” debate is really about whether we can expect things to be somewhat better or somewhat worse six months out from now. In either case, things really are really bad right now. And a whole bunch of states including large ones like California and Pennsylvania—are soon to implement substantial cutbacks in services at just the time when the objective need for social services is going up.

The near-term fiscal pressures state and local governments will face is one of the things that concerns me most looking at the economy moving forward. Most of these governments are required by law to balance their budgets. As tax receipts fall, cuts must follow. Although there's certainly an argument to be made that many state and local governments are bloated, a period of economic distress is an inopportune time to reduce spending. Cuts by these entities have the potential to counteract any spending increases by the federal government and send our economy plunging.

One only needs to look at the Great Depression for proof. Most high school history classes teach you that the federal government used the New Deal to boost the economic recovery. What they fail to mention--which you can see below--is that state and local governments ran surpluses to balance out the federal spending. If my memory serves me correct (I can't find the actual numbers), federal, state, and local governments ran an aggregate SURPLUS for most of the Great Depression, with the state and local governments essentially nullifying any impact of FDR's fiscal stimulus. Only during World War II did the U.S. finally return to producing at its maximum capability. I really hope we don't forget that lesson.


Source: Econobrowser