The fallacy of causation and corporate profits

by Michael Roberts

Paul Krugman recently launched into a new attack on the priests of neoclassical economics, Eugene Fama (the new Nobel prize winner – see my  post, http://thenextrecession.wordpress.com/2013/10/14/the-noblest-fama-and-shiller/) and John Cochrane in a recent post (http://krugman.blogs.nytimes.com/2013/10/16/fallacies-of-immaculate-causation/). Krugman reckoned that Fama had committed an error of ‘immaculate causation’ whereby Fama started with an accounting identity, in this case savings = investment, and treated it as a causal relationship, namely savings => (leads to) investment, but makes no attempt to prove that this is the direction of causation.  As Krugman says: “Why not the other way around?” After all, he says that Keynesian models do the opposite of Fama’s neoclassical (Say’s law) causation and reckon the “investment (determined by animal spirits) does in fact determine the level of savings.”

Krugman goes onto argue that if consumers (for some reason due to a change of ‘animal spirits’) start to save more, the accounting identity is only maintained by producers running up more investment in the form of unsold inventories.  So investment then equals savings in an environment of overproduction.  For Krugman and the Keynesians, the only way higher savings could lead to higher investment without causing ‘overproduction’ would be if interest rates fell, encouraging producers to invest more voluntarily.  And that won’t happen in an economic world where interest rates are already zero, as now.  Thus Say’s law (that supply or savings causes its own demand or investment) and Fama’s direction of causation are nonsense.

Indeed, recently Brad de Long, another Keynesian guru, pointed out that Say himself eventually rejected his own law (http://delong.typepad.com/sdj/2013/10/macroeconomics-in-the-public-square-part-iiib-of-my-the-economist-as-the-public-square-and-economists-equitable-growth.html): “By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: “every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared…”  Say reckoned that the overproduction or glut in commodities was due to a sudden flight to financial assets.  In other words, Say confirmed the Keynesian theory that crises are caused by extreme ‘liquidity preference’ on the part of consumers who stop spending and hold their money and a collapse of ‘confidence’ by investors.

De Long goes onto to explain why that should suddenly happen: “these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera.”  Well, that’s a long list of irrational and speculative causes of crises, along with more rational causes like expectation of future profit.  If all these are causes, we’ll never know what can cause sudden and drastic collapses like the Great Recession – it’s just instability.

Krugman says “accounting identities can only tell you so much. Anyone who claims that the identities tell you everything you know, without an actual model of how things work, is just doing bad economics.”  Yes, bad economics.  It is in the causal direction of these accounting identities that Marx parts with Keynes.  And here is the irony in Krugman attacking Fama.  Keynes (and Krugman) tells us that the direction of the causation is from investment to savings.  But this is not realistic if the only ‘proof’ is that investment is moved by the psychological mysticism of ‘animal spirits’ or ‘confidence’ (see my post, http://thenextrecession.wordpress.com/2012/04/21/paul-krugman-steve-keen-and-the-mysticism-of-keynesian-economics/).  Keynesian theory falls back on the irrational and speculative behaviour of individual consumers or investors (thus we have the work of that other Nobel prize winner, Robert Shiller – see my post, op cit).  There is no recognition of the objective reality of profit.  So the Keynesians have their causation in the wrong direction.

Before savings and before investment is the generation of profit (or surplus value) from the activity of labour in the production process.  Marxist economics says that it is not the speculative irrationality of investors, but the objective movement of profit that decides whether the owners of that profit will invest more or less.  What’s the proof of that?  Well, many Marxist studies have shown the causal connection between profit and investment, in that order. The Keynesian models present a myriad of causes and a myriad of causes provides no theory of crises at all.

Shiller’s (noble) contribution was that the Great Recession could have been predicted by ‘excessively’ high stock market prices relative to corporate earnings (profit) and excessively high property prices compared to household income prior to 2007.  At least, this shows some objective empirical evidence and is not really based on any models of the psychological motivations of consumers or speculators.  Financial and property markets were just way out of line with profits and workers’ incomes in 2007.  Capital values were mostly fictitious, as Marx would have said.  But what is decisive here is the level of profit and profitability, not the level of stock or real estate prices.

The other irony is this means that the neoclassical (Fama) direction of causation going from savings to investment is actually closer to reality than Keynes and Krugman – but for different reasons from Fama.  For if we assume that workers save little or nothing and consume all their wages, and we exclude the impact of government net spending or savings, then savings are entirely composed of profit.  ‘Profit calls the tune’, to reverse the phrase of radical Keynesian Hyman Minsky, now so popular among radical left economists, who coined the aphorism that ‘investment calls the tune’
(see my post, http://thenextrecession.wordpress.com/2012/06/26/profits-call-the-tune/).

The Keynes-Kalecki accounting identity was recently dug up again by another Keynesian, Cullen Roche, in a recent post (http://seekingalpha.com/article/1753482-budget-deficits-contribute-to-corporate-profits-but-dont-matter-right).  According to Roche, profits depend on investment minus what households and government save.  He admits that “It’s strange to think of the government as a source of profits because some people don’t generally like to think that the government is a large source of private sector profits.  But that really shouldn’t surprise anyone.  After all, when the government pays contractors in Virginia to build planes then those payments get listed as corporate revenues which contribute to the bottom line of corporations.  And when you net out investment, household savings, foreign savings and dividends you get the total of corporate profits.”

But ‘some people’ are right.  Government is not the source of even these profits. Profit does not come from investment or government spending – that’s nonsensical.  Reality is the opposite. Profits come from the unpaid labour of workers and then are distributed to shareholders, government and foreigners, with what’s left being reinvested.  Dividends come from profits not profits from dividends, as Roche wants us to think. Thus Roche repeats a Keynesian-Kalecki version of Krugman’s ‘fallacy of immaculate causation’.

Moreover, this leads to serious error in economic policy, as I have shown in a previous post (http://thenextrecession.wordpress.com/2012/06/13/keynes-the-profits-equation-and-the-marxist-multiplier/).  If the Keynes-Kalecki causal direction were right, it would mean that if government increases spending and widens its budget deficit and consumers save less and spend more, then capitalist investment will rise.  As a result, profits will rise with investment and capitalism will be saved, thanks to government spending.  But if it were the opposite causal direction as Marxist economic argues, namely that profits get ‘used up’ by investment and government deficits, then profits come from outside the accounting identity (namely they are exogenous) and the only way investment will rise is if there are lower not larger government deficits and more saving by consumers or foreigners, not less.

And this is the real logic of capitalist austerity policies – reducing the surplus value created by labour being siphoned off to government spending or into workers savings.  How?  Well, raise taxation on workers, reduce corporate taxes and cut ‘unnecessary’ government services.

Roche wants to claim that more government spending will boost investment and thus profits.  But he actually shows in his post that government spending has been slashed during the recession and yet profits are at record highs. So how does that work?  ‘Austerity’ and deleveraging, and most important, a huge squeeze on labour’s income share, have raised profits, not more government spending.  As we know from many sources, including this blog, profits have been booming in

America, reaching the highest proportion of GDP since the second world war.
The issue we have been debating in this blog and elsewhere is why US business investment to GDP is still close to the lows of previous cycles. Instead of investing, businesses are handing cash back to shareholders through buybacks and dividend increases and hoarding cash. In 2011, the value of American share buy-backs was equal to 2.7% of GDP; in Britain, the figure was 3.1%.

In the early 1970s American companies invested 15 times as much cash as they distributed to shareholders; in recent years the ratio has dropped back to below two (see chart).  In his new book, The Road to Recovery: How and Why Economic Policy Must Change, Andrew Smithers, very much a mainstream economist, argues that the main cause has been management incentives. Executives are now paid largely in the form of bonuses rather than salary. These bonuses are often tied to the share price, which in turn depends on the ability of the company to meet its quarterly earnings-per-share target. Buy-backs tend to boost earnings per share; investment plans may dent them.  Indeed, according to the national accounts, American companies have been paying out in cash more than 100% of their domestic profits to shareholders.  There is barely a sign in the national accounts of a fall in the ratio of non-financial corporate debt to GDP. As a result, the dangers of high debt are underestimated. A collapse in asset prices could still provoke a crisis.

Smithers is arguing that company management prefer to boost stock prices than invest in productive capacity.  He reckons this is due to bonus schemes.  Well, it’s an argument.  But it suggests that if management incentives are reformed, business investment will return.  I think the more likely explanation for relatively low investment remains with high debt relative to earnings in many smaller companies and still relatively low profitability (not profit) relative to corporate assets for the sector as a whole.

This explanation holds for European capitalism (see my recent post, http://thenextrecession.wordpress.com/2013/10/18/eurozone-corporate-profitability/) and for Japan
(see http://thenextrecession.wordpress.com/2013/02/14/japans-lost-decades-unpacked-and-repacked/).

I shall return to the question for the US.  But I don’t think it is an accident that relatively higher profit growth and profitability in the US compared to Europe has delivered relatively better business investment growth.