U.S. Economy

The final way for a corporation to pay for new investments is by

reinvesting some of the profits it has earned. After paying taxes,

profits are either paid out to stockholders as dividends or held as

retained earnings to use in running and expanding the business. Those

retained earnings come from the profits that belong to the stockholders,

so reinvesting some of those profits increases the value of what the

stockholders own and have risked in the business, which is known as

stockholders’ equity. On the other hand, if the corporation incurs

losses, the value of what the stockholders own in the business goes down,

so stockholders’ equity decreases.

Entrepreneurs and Profits

Entrepreneurs raise money to invest in new enterprises that produce goods

and services for consumers to buy—if consumers want these products more

than other things they can buy. Entrepreneurs often make decisions on

which businesses to pursue based on consumer demands. Making decisions to

move resources into more profitable markets, and accepting the risk of

losses if they make bad decisions—or fail to produce products that stand

the test of competition—is the key role of entrepreneurs in the U.S.

economy.

Profits are the financial incentives that lead business owners to risk

their resources making goods and services for consumers to buy. But there

are no guarantees that consumers will pay prices high enough to cover a

firm’s costs of production, so there is an inherent risk that a firm will

lose money and not make profits. Even during good years for most

businesses, about 70,000 businesses fail in the United States. In years

when business conditions are poor, the number approaches 100,000 failures

a year. And even among the largest 500 U.S. industrial corporations, a

few of these firms lose money in any given year.

Entrepreneurs invest money in firms with the expectation of making a

profit. Therefore, if the profits a company earns are not high enough,

entrepreneurs will not continue to invest in that firm. Instead, they

will invest in other companies that they hope will be more profitable. Or

if they want to reduce their risk, they can put their money into savings

accounts where banks guarantee a minimum return. They can also invest in

other kinds of financial securities (such as government or corporate

bonds) that are riskier than savings accounts, but less risky than

investments in most businesses. Generally, the riskier the investment,

the higher the return investors will require to invest their money.

Calculating Profits

The dollar value of profits earned by U.S. businesses—about $700 billion

a year in the late 1990s—is a great deal of money. However, it is

important to see how profits compare with the money that business owners

have risked in the business. Profits are also often compared to the level

of sales for individual firms, or for all firms in the U.S. economy.

Accountants calculate profits by starting with the revenue a firm

received from selling goods or services. The accountants then subtract

the firm’s expenses for all of the material, labor, and other inputs used

to produce the product. The resulting number is the dollar level of

profits. To evaluate whether that figure is high or low, it must be

compared to some measure of the size of the firm. Obviously, $1 million

would be an incredibly large amount of profits for a very small firm, and

not much profit at all for one of the largest corporations in the

country, such as telecommunications giant AT&T Corp. or automobile

manufacturer General Motors (GM).

To take into consideration the size of the firm, profits are calculated

as a percentage of several different aspects of the business, including

the firm’s level of sales, employment, and stockholders’ equity. Various

individuals will use one of these different methods to evaluate a

company’s performance, depending on what they want to know about how the

firm operates. For example, an efficiency expert might examine the firm’s

profits as a percentage of employment to determine how much profit is

generated by the average worker in that firm. On the other hand,

potential investors and a company’s chief executive would be more

interested in profit as a percentage of stockholder equity, which allows

them to gauge what kind of return to expect on their investments. A sales

executive in the same firm might be more interested in learning about the

company’s profit as a percentage of sales in order to compare its

performance to the performances of competing firms in the same industry.

Using these different accounting methods often results in different

profit percent figures for the same company. For example, suppose a firm

earned a yearly profit of $1 million, with sales of $20 million. That

represents a 5-percent rate of profit as a return on sales. But if

stockholders’ equity in the corporation is $10 million, profits as a

percent of stockholders’ equity will be 10 percent.

Return on Sales

Year after year, U.S. manufacturing firms average profits of about 5

percent of sales. Many business owners with profits at this level or

lower like to say that they earn only about what people can earn on the

interest from their savings accounts. That sounds low, especially

considering that the federal government insures many savings accounts, so

that most people with deposits at a bank run no risk of losing their

savings if the bank goes out of business. And in fact, given the risks

inherent in almost all businesses, few stockholders would be satisfied

with a return on their investment that was this low.

Although it is true that on average, U.S. manufacturing firms only make

about a 5-percent return on sales, that figure has little to do with the

risks these businesses take. To see why, consider a specific example.

Most grocery stores earn a return on sales of only 1 to 2 percent, while

some other kinds of firms typically earn more than the 5-percent average

profit on sales. But selling more or less does not really increase what

the owners of a grocery store (or most other businesses) are risking.

Each time a grocery store sells $100 worth of canned spinach, it keeps

about one or two dollars as profit, and uses the rest of the money to put

more cans of spinach on the shelves for consumers to buy. At the end of

the year, the grocery store may have sold thousands of dollars worth of

canned spinach, but it never really risked those thousands of dollars. At

any given time, it only risked what it spent for the cans that were at

the store. When some cans were sold, the store bought new cans to put on

the shelves, and it turned over its inventory of canned spinach many

times during the year.

But the total value of these sales at the end of the year says little or

nothing about the actual level of risk that the grocery store owners

accepted at any point during the year. And in fact, the grocery industry

is a relatively low-risk business, because people buy food in good times

and bad. Providing goods or services where production or consumer demand

is more variable—such as exploring for oil and uranium, or making movies

and high fashion clothing—is far riskier.

Return on Equity

What stockholders risk—the amount they stand to lose if a business incurs

losses and shuts down—is the money they have invested in the business,

their equity. These are the funds stockholders provide for the firm

whenever it offers a new issue of stock, or when the firm keeps some of

the profits it earns to use in the business as retained earnings, rather

than paying those profits out to stockholders as dividends.

Profits as a return on stockholders’ equity for U.S. corporations usually

average from 12 to 16 percent, for larger and smaller corporations alike.

That is more than people can earn on savings accounts, or on long-term

government and corporate bonds. That is not surprising, however, because

stockholders usually accept more risk by investing in companies than

people do when they put money in savings accounts or buy bonds. The

higher average yield for corporate profits is required to make up for the

fact that there are likely to be some years when returns are lower, or

perhaps even some when a company loses money.

At least part of any firm’s profits are required for it to continue to do

business. Business owners could put their funds into savings accounts and

earn a guaranteed level of return, or put them in government bonds that

carry hardly any risk of default. If a business does not earn a rate of

return in a particular market at least as high as a savings account or

government bonds, its owners will decide to get out of that market and

use the resources elsewhere—unless they expect higher levels of profits

in the future.

Over time, high profits in some businesses or industries are a signal to

other producers to put more resources into those markets. Low profits, or

losses, are a signal to move resources out of a market into something

that provides a better return for the level of risk involved. That is a

key part of how markets work and respond to changing demand and supply

conditions. Markets worked exactly that way in the U.S. economy when

people left the blacksmith business to start making automobiles at the

beginning of the 20th century. They worked the same way at the end of the

century, when many companies stopped making typewriters and started

making computers and printers.

CAPITAL, SAVINGS, AND INVESTMENT

In the United States and in other market economies, financial firms and

markets channel savings into capital investments. Financial markets, and

the economy as a whole, work much better when the value of the dollar is

stable, experiencing neither rapid inflation nor deflation. In the United

States, the Federal Reserve System functions as the central banking

institution. It has the primary responsibility to keep the right amount

of money circulating in the economy.

Investments are one of the most important ways that economies are able to

grow over time. Investments allow businesses to purchase factories,

machines, and other capital goods, which in turn increase the production

of goods and services and thus the standard of living of those who live

in the economy. That is especially true when capital goods incorporate

recently developed technologies that allow new goods and services to be

produced, or existing goods and services to be produced more efficiently

with fewer resources.

Investing in capital goods has a cost, however. For investment to take

place, some resources that could have been used to produce goods and

services for consumption today must be used, instead, to make the capital

goods. People must save and reduce their current consumption to allow

this investment to take place. In the U.S. economy, these are usually not

the same people or organizations that use those funds to buy capital

goods. Banks and other financial institutions in the economy play a key

role by providing incentives for some people to save, and then lend those

funds to firms and other people who are investing in capital goods.

Interest rates are the price someone pays to borrow money. Savings

institutions pay interest to people who deposit funds with the

institution, and borrowers pay interest on their loans. Like any other

price in a market economy, supply and demand determine the interest rate.

The demand for money depends on how much money people and organizations

want to have to meet their everyday expenses, how much they want to save

to protect themselves against times when their income may fall or their

expenses may rise, and how much they want to borrow to invest. The supply

of money is largely controlled by a nation’s central bank—which in the

United States is the Federal Reserve System. The Federal Reserve

increases or decreases the money supply to try to keep the right amount

of money in the economy. Too much money leads to inflation. Too little

results in high interest rates that make it more expensive to invest and

may lead to a slowdown in the national economy, with rising levels of

unemployment.

Providing Funds for Investments in Capital

To take advantage of specialization and economies of scale, firms must

build large production facilities that can cost hundreds of millions of

dollars. The firms that build these plants raise some funds with new

issues of stock, as described above. But firms also borrow huge sums of

money every year to undertake these capital investments. When they do

that, they compete with government agencies that are borrowing money to

finance construction projects and other public spending programs, and

with households that are borrowing money to finance the purchase of

housing, automobiles, and other goods and services.

Savings play an important role in the lending process. For any of this

borrowing to take place, banks and other lenders must have funds to lend

out. They obtain these funds from people or organizations that are

willing to deposit money in accounts at the bank, including savings

accounts. If everyone spent all of the income they earned each year,

there would be no funds available for banks to lend out.

Among the three major sectors of the U.S. economy—households, businesses,

and government—only households are net savers. In other words, households

save more money than they borrow. Conversely, businesses and government

are net borrowers. A few businesses may save more than they invest in

business ventures. However, overall, businesses in the United States,

like businesses in virtually all countries, invest far more than they

save. Many companies borrow funds to finance their investments. And while

some local and state governments occasionally run budget surpluses,

overall the government sector is also a large net borrower in the U.S.

economy. The government borrows money by issuing various forms of bonds.

Like corporate bonds, government bonds are contractual obligations to

repay what is borrowed, plus some specified rate of interest, at a

specified time.

Matching Borrowers and Lenders in Financial Markets

Households save money for several reasons: to provide a cushion against

bad times, as when wage earners or others in the household become sick,

injured, or disabled; to pay for large expenditures such as houses, cars,

and vacations; to set aside money for retirement; or to invest. Banks and

other financial institutions compete for households’ savings deposits by

paying interest to the savers. Then banks lend those funds out to

borrowers at a higher rate of interest than they pay to savers. The

difference between the interest rates charged to borrowers and paid to

savers is the main way that banks earn profits.

Of course banks must also be careful to lend the money to people and

firms that are creditworthy—meaning they will be able to repay the loans.

The creditworthiness of the borrower is one reason why some kinds of

loans have higher rates of interest than others do. Short-term loans made

to people or businesses with a long history of stable income and

employment, and who have assets that can be pledged as collateral that

will become the bank’s property if a loan is not repaid, will receive the

lowest interest rates. For example, well-established firms such as AT&T

often pay what is called the bank’s prime rate—the lowest available rate

for business loans—when they borrow money. New, start-up companies pay

higher rates because there is a greater risk they will default on the

loan or even go out of business.

Other kinds of loans also have greater risks of default, so banks and

other lenders charge different rates of interest. Mortgage loans are

backed by the collateral of the property the loan was used to purchase.

If someone does not pay his or her mortgage, the bank has the right to

sell the property that was pledged as collateral and to collect the

proceeds as payment for what it is owed. That means the bank’s risks are

lower, so interest rates on these loans are typically lower, too. The

money that is loaned to people who do not pay off the balances on their

credit cards every month represents a greater risk to banks, because no

collateral is provided. Because the bank does not hold any title to the

consumer’s property for these loans, it charges a higher interest rate

than it charges on mortgages. The higher rate allows the bank to collect

enough money overall so that it can cover its losses when some of these

riskier loans are not repaid.

If a bank makes too many loans that are not repaid, it will go out of

business. The effects of bank failures on depositors and the overall

economy can be very severe, especially if many banks fail at the same

time and the deposits are not insured. In the United States, the most

famous example of this kind of financial disaster occurred during the

Great Depression of the 1930s, when a large number of banks failed. Many

other businesses also closed and many people lost both their jobs and

savings.

Bank failures are fairly rare events in the U.S. economy. Banks do not

want to lose money or go out of business, and they try to avoid making

loans to individuals and businesses who will be unable to repay them. In

addition, a number of safeguards protect U.S. financial institutions and

their customers against failures. The Federal Deposit Insurance

Corporation (FDIC) insures most bank and savings and loan deposits up to

$100,000. Government examiners conduct regular inspections of banks and

other financial institutions to try to ensure that these firms are

operating safely and responsibly.

U.S. Household Savings Rate

A broader issue for the U.S. economy at the end of the 20th century is

the low household savings rate in this country, compared to that of many

other industrialized nations. People who live in the United States save

less of their annual income than people who live in many other

industrialized market economies, including Japan, Germany, and Italy.

There is considerable debate about why the U.S. savings rate is low, and

several factors are often discussed. U.S. citizens may simply choose to

enjoy more of their income in the form of current consumption than people

in nations where living standards have historically been lower. But other

considerations may also be important. There are significant differences

among nations in how savings, dividends, investment income, housing

expenditures, and retirement programs are taxed and financed. These

differences may lead to different decisions about saving.

For example, many other nations do not tax interest on savings accounts

as much as they do other forms of income, and some countries do not tax

at least part of the income people earn on savings accounts at all. In

the United States, such favorable tax treatment does not apply to regular

savings accounts. The government does offer more limited advantages on

special retirement accounts, but such accounts have many restrictions on

how much people can deposit or withdraw before retirement without facing

tax penalties.

In addition, U.S. consumers can deduct from their taxes the interest they

pay on mortgages for the homes they live in. That encourages people to

spend more on housing than they otherwise would. As a result, some funds

that would otherwise be saved are, instead, put into housing.

Another factor that has a direct effect on the U.S. savings rate is the

Social Security system, the government program that provides some

retirement income to most older people. The money that workers pay into

the Social Security system does not go into individual savings accounts

for those workers. Instead, it is used to make Social Security payments

to current retirees. No savings are created under this system unless it

happens that the total amount being paid into the system is greater than

the current payments to retirees. Even when that has happened in the

past, the federal government often used the surplus to pay for some of

its other expenditures. Individuals are also likely to save less for

their own retirement because they expect to receive Social Security

benefits when they retire.

The low U.S. savings rate has two significant consequences. First, with

fewer dollars available as savings to banks and other financial

institutions, interest rates are higher for both savers and borrowers

than they would otherwise be. That makes it more costly to finance

investment in factories, equipment, and other goods, which slows growth

in national output and income levels. Second, the higher U.S. interest

rates attract funds from savers and investors in other nations. As we

will see below, such foreign investments can have several effects on the

U.S. economy.

Borrowing from Foreign Savers

The flow of funds from other nations enables U.S. firms to finance more

investments in capital goods, but it also creates concerns. For example,

in order for foreigners to invest in U.S. savings accounts and U.S.

government or corporate bonds, they must have dollars. As they demand

dollars for these investments, the price of the dollar in terms of other

nations’ currencies rises. When the price of the dollar is rising, people

in other countries who want to buy U.S. exports will have to pay more for

them. That means they will buy fewer goods and services produced in the

United States, which will hurt U.S. export industries. This happened in

the early 1980s, when U.S. companies such as Caterpillar, which makes

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