Primer: The Kalecki Profit Equation (Part II)

This article continues the discussion of the Kalecki Profit Equation (link to Part I). The Kalecki Profit Equation is an account identity (a statement that is true by definition) that determines the level of aggregate business sector profits in terms of other national accounts variables. The full equation is somewhat imposing, so the strategy employed here is to build up the equation by starting off with a simplified model economy that results in a brief equation, then adding new terms progressively. The previous article noted that investment creates a pro-cyclical self-reinforcing loop between it and profits. This article discusses two factors that normally act to moderate the business cycle: the fiscal deficit, and the external sector.

As in the previous article, the treatment here is aimed at the simplified economic model accounting, and not the full details of the national accounts. If one wanted to apply the accounting identity to real world national accounts, there are a great many smaller terms that would need to be added in in order to get the full accounting identity.

Model 4: Government Fiscal Policy

The previous article started off with a simple two sector economic model, with the two sectors being the business sector and households. The last model considered was Model 3, and had an associated profit equation:

(Model 3 Profits) = (Net Investment) - (Household savings) + (Dividend payments).

We will now add a third sector: the general government sector. We will label this Model 4.

(Model 4 Profits) = (Net Investment) - (Household savings) + (Dividend payments) + (Government Fiscal Deficit).

The addition of the government sector added the final term to the equation -- the fiscal deficit. This is a fairly conventional phrasing, but it must be kept in mind that the fiscal deficit is the negative of the fiscal balance, so we need to flip signs if we want to use the fiscal balance as the variable. The usual condition for governments is to run deficits, so it is more familiar to express the equation using it.

The reason why a fiscal deficit creates profits is that the government is now injecting cash into the circular flows in the economy. If the government mails a senior a $100 transfer payment, and said senior immediately runs out and spends it, that represents $100 in business sector revenue that is not matched to any wage expenses.

(I am following the convention of economic models, and treating government spending as consumption. If governments capitalised some investment expenditures, those expenditures might not be considered part of the fiscal deficit, and they would need to be added into the profit equation.)

For profits, the full fiscal balance matters, not just the primary balance (the balance excluding interest payments). Mainstream economic analysis often likes to focus on the primary balance, but this glosses over the reality that interest payments by the government are an income source to the non-governmental sector.

The presence of the fiscal deficit in the profit equation is an important part of the counter-cyclical nature of fiscal policy. Mainstream economic models attempt to gloss over the the importance of profits on the basis that competition allegedly causes profits to wither away. However, in a recession, deficits naturally grow -- the tax take falls, while welfare state spending (such as unemployment insurance) automatically increases. Furthermore, even fiscal conservatives tend to panic in a downturn, adding active stimulus measures to the mix. The rising contribution of the fiscal deficit will counter-act the drop in investment, putting a floor under profits (and animal spirits) in the private sector.

During an expansion, fiscal deficits tend to contract (or least grow less than GDP in nominal terms). This acts as an increasing drag on profits, counter-acting the pro-cyclical impetus from investment.

In summary, a focus on the interaction between the fiscal deficit and profits gives a much greater weight on fiscal policy than an approach based on appealing to the so-called inter-temporal governmental budget constraint would suggest.

Model 5: The External Sector

 The final addition to the profit equation is to bring in the external sector (imports and exports). If a country has net imports of goods, it implies that net cash flows are heading to foreign entities -- implying a loss in the circular flow of income.

The addition of the external sector adds a new wrinkle -- the profits that we are discussing here are domestic profits, which is not the same thing as national profits. A local firm may have profits in its foreign subsidiaries, but those will not show up in the domestic national accounts. A stock market investor is interested in the total profits of firms, and not just domestic profits, so the distinction needs to be kept in mind.

(Model 5 Profits) = (Net Investment) - (Household savings) + (Dividend payments) + (Government Fiscal Deficit) - (Net Imports).

The breakage in cash flows is straightforward. If a worker spends $100 on imported goods out of wage income, the source of the wages was an expense to the domestic business sector, while the domestic sector gains no revenue.

This raises a different perspective on the question of protectionism. From the perspective of optimising decisions of households, free trade is an obvious advantage, as it opens the opportunity set for consumption purposes. However, a trade deficit is a negative for domestic corporate profits.

If we assume that imports as a percentage of total domestic consumption is stable (the propensity to consume), import growth will equal the domestic growth rate. Meanwhile, exports would tend to grow at the growth rate of our export markets. The implication is that if our domestic growth rate is greater than elsewhere, the trade balance will tend to fall. For the "Anglo" countries (such as the United States) in recent decades, trade deficits will tend to rise during an expansion. As a result, the external sector will tend to act in a stabilising fashion for profits. This will be less true for countries following an export-led growth dynamic, as the persistent trade surplus will tend to move in tandem with the global business cycle.

Concluding Remarks

We have slowly built up the Kalecki Profit equation to a fairly general form. We would need to adapt it to take into accounts various technicalities in the national accounts if we wanted to apply it to real world data. I am unconvinced about the value of such an exercise, since it is unlikely that we could forecast each of the components of the full equation. Meanwhile, if we are not interested in forecasting, we can just read off profits from the national accounts, rather than calculating them with an accounting identity. Instead, the value of the accounting identity is for the analysis of models, and getting a high level understanding of the nature of the dynamics.

For example, one notes that the wage bill does not appear in the equation. That is, rising wages are not necessarily a negative for profits -- which is not obvious if we pursue a bottom up microeconomic perspective. Rising wages would presumably allow for greater household savings (which does appear in the equation), but that is a second order effect.

However, the most important take away is the importance of investment for the business cycle. Businesses invest on the expectation of greater future profits -- and investment is a source of aggregate profits. Central banks playing around with the money supply is at most a speed bump  in the way of the self-reinforcing growth dynamics of industrial capitalism.

From a policy perspective, Minsky argued that this accounting logic implies the need for a relatively large central government to tame the business cycle. Small governments (5-10% of GDP, which was relatively normal peacetime share pre-World War II) will not generate a large enough cyclical swing in the fiscal deficit to cancel out the fixed investment cycle. The absence of the automatic stabilisers allows what would be recessions turn into depressions.

(c) Brian Romanchuk 2018