Profits, Deficits and Instability

The papers in this volume were presented and discussed at the inaugural conference on ‘Profits and Instability’ of The Jerome Levy Economics Institute of Bard College on 16–18 March 1989. The purpose of the conference was to discuss recent research findings on various aspects of profits, deficits and instability, and the connection of these findings among the three issues themselves and their relevance to economic policy as well. Concerns and worries about the future that focus on the question of whether America is number one situate the problems of profitability, increasing debt and economic stability at centre stage.

Some four score years ago Jerome Levy had the insight that the cyclical behaviour of a capitalist economy depends upon the course of profits through time, and that this course depends upon the structure of what we would now call aggregate demand. In particular Jerome Levy advanced the proposition that in a simple small government capitalist economy, with external trade mostly in balance, total profits equals investment. In the argument that follows upon this insight, investment is shown to be the independent variable and profits the dependent variable. This leads to a simple equation: Profits = Investment.¹ In thinking about economics as he did, Jerome Levy anticipated the economics of Keynes and Kalecki.

The total profits obtained in an economy in a particular interval of time is a macroeconomic variable, and it can be shown to be determined by the net effects of four other macroeconomic variables. These variables are gross private domestic investment, the government deficit, net foreign investment and personal saving. This approach to the determination of profits can be traced to Kalecki (1954), but there are strong hints of it in the Marxist literature on the realisation of profits. There are encouraging signs that this general approach is gaining wider currency. It has a prominent role in two recent publications, Levy and Levy (1983), and Minsky (1986).

The general concept of a wage-profit frontier provides a theoretical framework for studying the issues of technical change and income distribution. It can also be given empirical content as a vehicle for understanding movements in the rate of profit over time. This chapter first links up the more familiar wage-rate profit-rate frontier to the more empirically tractable wage-share profit-rate frontier in the context of a discussion of technical change and the rate of profit. The theory of technical change developed motivates an empirical model of the wage-share profit-rate frontier which is used to analyse movements in the rate of profit in US manufacturing industries from 1949 to 1987. Recent movements since about 1970 provide support for an old thesis that capital-using, labour-saving technical changes can, under some circumstances, reduce the rate of profit.

The central driving force behind a capitalist economy is the pursuit of profits. Profits provide a critical source of financing for capital expansion which results in future profit growth, and create the basis upon which markets assign values to companies and industries. Economists and financial professionals have shown a renewed interest in the determinants of profit change as the inflation experience of the 1970s indicated that profit levels and growth can be artificially inflated during periods of rapid price change. Inflation induced profit growth is the result of calculating inventory profit on an historical cost basis rather than on a replacement cost basis and under depreciating assets during periods when the replacement cost of capital is rising. In both instances the firm and/or the industry records positive incremental profit change which is only transitory.

Two views about competition exist. The first sees competition as a process for allocating resources to their optimal uses. The price mechanism is the instrument for achieving this goal, and when it functions properly equilibria emerge with prices equated to marginal social costs of production. When it malfunctions, equilibria exist with some prices above marginal costs, and society suffers a welfare loss from the under-consumption of these goods. Such malfunctions are usually attributed to an insufficient number of buyers or sellers. Monopoly is seen as the antithesis of competition. Thus, under the first view, competition is seen as a process for determining prices and quantities, the allocation of resources for a given set of tastes and technological opportunities. At its zenith, competition produces an equilibrium set of prices which induce a Pareto optimal allocation of the economy’s goods and services. Such equilibria are anticipated so long as monopolistic elements are absent.

Most economic theories, both classical and neoclassical, assume a tendency for equalisation in profit rates both among industries within a country and among countries over time.¹ Indeed, in the Heckscher-Ohlin model, the key assumption made is that factor prices, both profit rates and wage rates, will tend toward equality both among industries and among countries.² Moreover, most theories assume that the equilibrating mechanism is the flow of capital to the industries and countries with relatively high profit rates. Surprisingly, the evidence on both of these hypotheses is rather scant.

At the 1988 meeting of the American Economic Association, Robert Eisner used the first few minutes of his presidential address to urge economists to make expectational dynamics a major focus of attention. In particular, he reminded us that when we

introduce as arguments in an investment function such variables as current and past output, sales, or utilisation of capacity, current or past profits, cash flow or measures of liquidity, and current or past interest rates, depreciation rates, and relative rental price or user costs of capital, … our theory tells us that the arguments we generally need are … the expected future values of those variables. Firms should invest if they expect the future demand for output to be high, if they expect the cost of capital to be higher in the future than now, and if they look to higher future profits as a consequence of current investment, but little if at all in response to current or past values of these variables. (Eisner, 1989, pp. 1–2)

In this chapter we shall be looking at work which has been done on corporate births and deaths. We shall also be presenting new work which looks at the determinants of the average liabilities with which firms fail. We hope to show that profits perform a crucial role in the Schumpeterian cycle, encouraging the establishment of new firms, as well as ensuring that the inefficient firm or the firm in a declining industry does not utilise scarce resources which could be better employed elsewhere. However, we will also be arguing that this role is not performed as efficiently as it might be and that government restrictions on the invisible hand can actually improve the efficiency of the supply side of the economy. In particular we will argue that bankruptcies impose costs upon an economy, costs which the American bankruptcy system does more to minimise than European systems.

Much of macroeconomic analysis, outside of fiscal policy, runs in terms of the quantity of money. Velocity is assumed to be constant, or to vary only within narrow limits. Control the money supply, the monetarists claim, and you control national income, more or less, but at any rate within a comfortable range.

One of the most striking developments in the US economy over the past decade has been the growth of private sector debt. Highly publicised leveraged buy-outs and financial restructurings have saddled the corporate sector with levels of debt that are unprecedented in the post-war period. High consumer spending has fuelled the long expansion of the mid-1980s, but it has been financed with credit, putting the household sector deeply in debt.

Economists dissatisfied with the conventional theory of the firm have recently begun to examine the connections between a corporation’s pricing and investment decisions. Prices are seen as linked to potential output, rather than to current output, as in conventional theory. Perfectly competitive firms, according to the latter, take prices as given and choose the optimal output, while in imperfect markets firms take the demand curve as given and choose the optimal combination of price and current output. In both cases productive capacity and the cost structure are taken as given. This may be reasonable for a small family firm, which at the outset makes a once-for-all choice of its optimal size, thereafter adjusting its current activity to changing conditions. But modern industrial corporations do not choose an optimal size; they invest regularly and grow. The conventional picture is not so much wrong as out of place — it is as though someone had painted a scene from the Middle West and tried to pass it off as a portrait of the Rockies. There are similarities, to be sure. The sky is blue and the grass is green, in both cases, and the sky lies above the land. Granted, but prairies are not mountains; it is not even ‘as if’ they were mountains. Corporate firms grow, and their pricing policies must be understood in relation to their growth if we are to accurately picture how the modern economy works.¹

My message in this chapter is that deficits can be good for you. In fact, deficits can be too large, and they can be too small. But we cannot tell which until we know how to measure them. And most people talking about deficits really have no notion how they are measured. The fact is that the way we do measure them has very uncertain economic relevance, and, in particular, the US federal budget and the deficit are calculated in a way which would send chills up the spines of almost any sensible private business accountant.

This chapter attempts to re-situate the theory of effective demand within a dynamic non-equilibrium context. Existing theories of effective demand, which derive from the works of Keynes and Kalecki, are generally posed in static equilibrium terms. That is to say, they serve to define a given level of output which corresponds to the equilibrium point between aggregate demand and supply. We propose to generalise this analysis in three ways. First, we shall extend the analysis to encompass a dynamic, that is, moving short-run path of output, rather than a merely static level. Second, we shall show that this dynamic short-run path need not imply an equilibrium analysis, since it can arise from either stochastically sustained cycles or deterministic limit cycles.¹ And third, we will provide generalisation of the theory of effective demand and a possible solution in the instability of warranted growth.

The purpose of this chapter is to discuss the importance of profitability. This issue has been at the centre of our research programme for several years¹ and the present essay is a synthesis of several earlier aspects of our work. Our organising theme concerning the importance of profitability is that Profitability matters because it is one important determinant of stability.

There has been much recent interest in the problem of financial instability in the macro economy. Some researchers have looked for cyclical and secular co-movements between debt accumulation, financial crises, and problems in the real economy. Others have tried to rationalise, in formal models, the apparent connections between finance, changes in expectations, and macro instability. Two different points of view are embodied in this work. One, deriving from the work of Minsky, emphasises the importance of ignorance and psychology. Firms are seen as financing accumulation on the basis of unverifiable expectations, accumulating debt burdens in the process. When the debt burdens are large enough, the economy becomes vulnerable to downward revisions of expectations. Such revisions reduce effective demand and stimulate financial crises. A second view emphasises a structural determinant of instability — declining profitability. Problems with profits are viewed as a major cause of debt burdens, and the source of potential financial crisis.

Recently, there have been several papers originating from Keynesian macroeconomic theory and Kalecki’s work on the business cycle that have attempted to integrate monetary and financial variables in macrodynamic models.¹ This development seems to overcome the unfortunate separation of financial and real aggregate magnitudes present in macrodynamic modelling. Moreover, due to the emphasis given to the role of financial markets for macro fluctuations, the formation of expectations has again been stressed as an important aspect in determining asset holding and investment decisions that generate macroeconomic fluctuations.² This chapter also seeks to make a contribution to this line of research. However, expectations or as we prefer to call them, a general state of confidence, will not be taken as given as in the Keynesian sense of ‘animal spirits’, but will be assumed as endogenous instead.

A real growth cycle model can be drawn up along neoclassical lines but based on adaptive expectations and temporary equilibrium instead of perfect foresight and intertemporal equilibrium as is done in most of the contemporary literature. Unlike the optimal growth version of the one sector model, which produces only monotonic growth that converges to a steady state or balanced growth path, in the adaptive case behaviour can, in addition to stable growth, exhibit periodic cycles or non-periodic, chaotic fluctuations. These various possibilities depend on the parameters of preference, productivity, expectational adjustment, the labour supply growth rate, the rate of technological advance and the rate of depreciation. When the model is viewed as a type of overlapping generations framework, cycles tend to look like 50-year Kondratieff fluctuations with one or two generations of increasing welfare followed by one or two generations that are relatively less well off.