Perhaps the only way to increase business profits at this juncture is to reduce government savings i.e. the government should run a deficit which is greater than the savings of the non-business sector.
With the eyes and ears of economists and economic commentators glued to GDP growth rate figures, it is easy to overlook other critical macroeconomic parameters that could give us important insights into the condition of an economy. Decades ago, one economist identified one such parameter; the Polish economist Michal Kalecki developed the “profits view” that focused on the implications of aggregate profits of businesses on the macroeconomy.
Unfortunately, macroeconomists hardly engage in any sustained discussion over it and policymakers pay scant attention to it. While industry leaders, shareholders and stock market participants are concerned over corporate profits, they care more about individual companies than aggregate profits of businesses.
Although we do not have data on aggregate profits of businesses, one can easily infer from general reports that business profits will be adversely affected from the uncertainty unleashed by the seemingly unstoppable spread of the Covid-19 virus as well as the ensuing lockdowns necessitated by the epidemic. Last month, Reliance Industries, India’s largest stock, announced a plunge in profits by almost 40 percent from a year earlier. The reports coming in of a sharp decline in profits of companies like TCS by 13 percent and D-Mart by some 88 percent in Q1 FY21 is worrisome. Overall, corporate profits are expected to show a decline by about 15 percent in FY21. Furthermore, MSME and informal businesses are likely to experience a much greater fall in profits this year.
But what is it that profits (bottom-line) can tell us about the economy that GDP (top-line or sales) cannot? What are the various components of the economy that affect and are affected by this decline in aggregate profits? Kalecki’s profits view helps answer these questions.
The profits equation
Michal Kalecki was considered one of the most distinguished economists of the 20th century. Many of his ideas were similar to those of Keynes and said to be conceived of before Keynes’ theories. However, macroeconomists have chosen to ignore Kalecki’s contributions even as economics, which purports to be a study of the free-market capitalism, has no theory of aggregate profits. The argument that a firm can increase its profits by cutting labour costs falls prey to the fallacy of composition because when all firms do so there would be large-scale reduction in total wages paid out, which in turn reduces spending by labour households and an overall shrinking of profits at the aggregate level. Similarly, the assertion that a firm can increase profits by cutting input or raw material costs fails to consider the impact of this on the revenues of other firms and as a consequence, on aggregate profits.
The crux of Kalecki’s profits view was to identify the source of profits, not of a single firm, but at the aggregate level, i.e. of all businesses. His discovery was stark and simple but a revelation nonetheless. His simple model assumes there are no savings by households, foreign sector and government and furthermore there are no dividends paid to shareholders.
The economy is divided into two sectors, the consumer goods sector and the investment goods sector. The consumer goods sector’s revenue is what the workers in the consumer goods sector spend plus what the workers in the investment goods sector spend on consumer goods. The profits or revenue less costs of the consumer goods sector would then be the revenue earned from the spending by investment goods sector workers. In the investment goods sector, the profits of these businesses are the revenue earned from the total amount of investment goods sold over and above the payment made to workers in this sector. To calculate the overall profits in the economy, the profits of both sectors are added resulting in a rather surprising realization that aggregate profits of businesses are nothing but investment spending on real capital goods by the businesses. As Kalecki put it, “Workers spend what they get, capitalists get what they spend”.
When this model is expanded to include other components, the profits equation shows that aggregate profits of businesses would be gross investment spending minus depreciation plus inventory investments plus corporate taxes and dividends minus the savings of the non-business sector (households), the savings of the foreign sector (current account deficit) and finally savings of the government sector (taxes less spending). This is Kalecki’s general profits equation. For the record, it is important to mention that Jerome Levy, businessman based in New York, had come up with a similar approach earlier so that the equation is often called the Kalecki-Levy Profits Equation.
An alternative view of the current crisis
Private sector investment spending is a key driver of economic growth, innovation and dynamism in capitalist economies. However, businesses are currently caught in a vicious circle. Unless profitability increases, investment may not and unless investment increases, profits will not. If this is the situation, the only way to get businesses to break out of this loop is to see whether other components of the Kalecki equation can be changed.
A major effect of the pandemic is the increased propensity to save due to people losing jobs, salary cuts and uncertainty over layoffs. Increased savings by households will act as a reduction in business profits and this is likely to worsen during the pandemic. It is important to point out that savings usually end up in stock markets and other physical and financial assets, which does not necessarily get converted into “real” investment, i.e. the key component to raise business profits.
On the external sector front, India is likely to face falling exports as well as falling imports due to lower GDP growth. The net effect is likely to be a balance in our current account.
A cursory analysis of the Kalecki profits equation shows that perhaps the only way to increase business profits at this juncture is to reduce government savings i.e. the government should run a deficit which is greater than the savings of the non-business sector.
The world is going through a tumultuous period due to the Covid-19 pandemic with many countries facing severe economic contractions and with it, high levels of unemployment. India too is caught in this predicament. However, restoring growth may not guarantee aggregate profits of businesses bouncing back. A deeper analysis of the interrelationships between the components of the Kalecki-Levy profits equation can yield important insights into macroeconomic crises and policies to overcome them.Sashi Sivramkrishna is a Modern Money Theory (MMT) researcher, economic historian and documentary filmmaker. Views are personal. Twitter@sashi 31363