Category Archives: political economy
A short note in reply to @Frances_Coppola. She disagreed with a paper from Jan Kregal at Levy.
Kregal argues that there are two types of deposit, deposits of currency and coin, and deposits created when loans are made. If a bank makes bad loans
“it is the failure of the holder of the second type of deposit [loan-created deposits] to redeem its liability that is the major cause of bank failure”
so the first type of depositor (of currency and coin) should not bear the brunt of these bad decisions.
Coppola disagrees with this on a theoretical point via twitter.
deposits physically deposited by customers are receipts of deposits created via someone else’s borrowing.
Here we agree to a point, reserves created by loan are spent in excess of the liquidity preference of the borrower and such ‘excess reserves’ creates reserves in other bank account and further expands the lending power of banks to lend on these reserves. We have modelled in detail this process before, as did many other banking theorists when the endogenous ex nihilo creation of money was taken for granted in banking textbooks.
But only to a point because there can be two sources of deposits (setting aside for a moment any debt free state created money) as Kregal correctly points out – Crusoe like savings from balances in excess of liquidity preference – and the endogenous creation of moneys through loans.
This must be true as balances immediately spent are not available as idle balances to be leveraged as lending. Also imagine a bank starting up, it cannot start up without equity, similarly a bank cannot expand beyond its capital ratios without raising additional equity.
This arises from the fundamental equation of accounting applied to the business model of banking, Assets=liabilities+owners equity. When a new bank, or a bank extending its capital base, creates a new loan it creates a liability now and an asset redeemable only in the future, to ensure positive balances the bank must raise equity, or its own liability through borrowing from another body, the two sides of the equation must balance. If it borrows the bank reduces its profits, hence why banks borrow short. This in no way implies a loanable funds view of money, rather future profits have two sources, saved existing money and loans, invested. It is the anticipation of the future stock of such money, not the present stock, which constrains lending decisions.
So even with the ex nihilo creation of deposits for loans, which create deposits for loans etc. etc. their is always a residue both of the original equity and the created money. In banks with high reserve requirements it will be higher but there will even be a residue in regimes with no reserve requirements.
This argument is formally the same to that of Bose (1980) in discussing the classical concept of ‘originary factors’ – and the ‘dated reduction’ of originary factors. Every commodity is composed of another commodity (a resource) and an input of labour. Going back through time we find natural resources and labour. This means that no commodity can be ever reduced to ‘pure labour’ or ‘pure commodities’ there is always a residue of one or the other. (Mathematically it is a Taylor series where ratios between the two are invariant over time). Here we have not referred to ‘capital’ rather purely the physical economy. However the circuit for the physical economy is paralleled by the reverse circuit of money. For the classicals ‘capital’ was simply money advanced for profit, including money advanced for wages and interest (quite correctly), and this money also has two sources, savings and loans. This leads to a rather interesting flow identity for a specific investment, prices, at effectual demand, equal:
commodities + labour = change in saving + change in debt
It does not matter if the change in saving is from retained profits (self funding) or change in savings to create bank equity and further capital for lending.
Update: I should have stressed here the LHS is the full cost price of production and the RHS is what the later classical economists (such as Tausseg) called the ‘pool of funding’ both measured as flow variables over (Wicksell’s term modifying Bohm -Bawerck) the ‘Period of investment’. Also we are talking about the change in savings and debt that is spent not retained in idle balences, so both are multiplied by the Davidson k factor (the proensity to hold income in balances).
But the value of labour here is simply the labour share (α ) times velocity ( α .v )which is the same as (1-r).v (r=the profits share, v = the velocity of money).
So we have a flow equation
Commodity price =(Δequity+ Δdebt)/ (α .v)
You can of course rearrange this equation to make endogenously created bank debt the dependent variable, but you cannot ever eliminate saving on the RHS, there is always a residue. These equations should come as no surprise, they can be derived from Kalecki’s stock identities modeled in a flow input, flow output system.
Two other interesting things about this identity. Declining labour share is inherently deflationary, indeed during the great moderation we saw deflation and declining labour share, and incomes and profits can only remain even with increasing debt, increasing savings for equity is also deflationary.
So what happens when labour share falls towards zero in an ‘android’ economy. I will explore this in a future post (it isn’t pretty).
(Note: At no point do I assume the such dated quantities can be ‘added up’ to equate values, Sraffa demonstrates the problems in this. Rather I assume that all such inputs are valued at current prices).
Marx on Exploitation and Inequality: An Essay in Marxian Analytical Economics
Production of Commodities by Means of Commodities Sraffa
The Economics of Enterprise (HJ Davenport) 1813
Collected Works, Kalecki
How do you make speculation endogenous to economic theory?
Further how do you make the full suite of potential profit making activities, speculation, hedging, arbitrage and investment endogenous?
By endogenous I mean a variable that is determined alongside other variables rather than outside the economic model.
The reasoning in this post comes was prompted in part from speculation by Steve Keen on to what extent the speculative drive is a necessary component of capitalism even though it is destabilising, partly from some dissatisfaction with the Minsky ‘Ponzi’ model of asset speculation, which has been too easily dismissed by neoclassicals as somehow individuals not behaving ‘rationally’. The model here is a generalisation of our earlier model of default risk in banking and insurance across all sectors.
In this model income not consumed – in the Keynesian vocabulary ‘saved’ – is split into a Tobinesque portfolio of investment, arbitrage, hedging or speculation. What about money held in bank balances? This is treated as speculation in that it is holding an asset, in this case money or near money, with some speculation about the retention of the purchasing power of money during the period with which it is held liquid. So then a portfolio is held with assets of varying degrees of liquidity, risk and expected return.
Imagine in an initial model perfect price information. Here arbitrage cannot exist so it simplifies to three variables.
Imagine a further wholly unrealistic simplification (which we will reject) that all expectations about future prices are correct. Here no profits can be made from speculation as all investment decisions will be made at correctly anticipated prices. Here there will be no risk premium on venture capital or corporate debt – and equity prices will instantly price in the results of successful investment. In such a world there would be alpha but no beta, or in more classical terms average profits but no excess profits. This shows the intimate relationship between speculation and investment. Once a financial asset is created by investment (whether debt or equity) that asset can be traded and speculated against. The initial investment provided financing the subsequent speculation does not, however if the price expectations of speculators raise prices of the financial asset it provide additional scope for financing of the investment term, either through raising new equity, extending loans (as the risks on the original loans are lowered) or through increased collateral (owners equity) allowing greater debt financing or investment through retained earnings.
An investment decision is a prediction of returns over period. Speculation involves estimations of whether there will excess profits or losses using knowable risks. Hedging is adopting the opposite position. So investment is a three way vector where any point on a future yield curve is the sum of the speculation vector (return x probability of return) and the hedge vector (loss X (1- probability of return)). Speculation and hedging being a zero sum game, they help prices of assets adjust to real prices but do not directly add to wealth, their effect is indirect.
Prior to Neidhoffer’s ‘The Speculator as Hero’ the tendency was to see speculation as entirely negative:
Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.
Neidhoffer shows is the amorality, rather than the immorality, of capitalism in this regard, much like the much misunderstood Machiavelli shows us the logic of political power. Speculation is an inevitable component of the price adjustment process when production or prices are not to expectations. This of course is not to say it is moral or the best means of allocating scarce resources (as for example when people might die before a new crop is grown or imports arrive).
Let us extend the unrealistic assumptions slightly by assuming that market agents do not know future prices but are able to successfully predict future risks, that is the probabilities of certain prices. This commits the ergodic fallacy, but lets test this expanded model for a moment. Here there is a role for speculation and hedging, indeed the prices of options, the prices of both can be calculated exactly. Here there is beta, but is simply impossible to know whether you will gain it, but you can adjust a portfolio to remove all downside risk by hedging, so you can guarantee alpha. Speculation and hedging are again a zero sum game.
How are prices different in this model from those in a world with no speculation and hedging? Speculation has a cost, it has a price, the cost is the cost of the hedge. This adds to the cost base of the firm and the price of goods (or the price of money if the commodity demanded is a loan). It shifts the supply curve upwards reducing the consumer surplus and increasing the producer surplus. This is not a disequilibriating facto, rather it defines a new pareto optimum position as the seller will not sell and the buyer will not buy without hedging risks. It defines the proper equilibrium position. As an additional risk it has an additional cost requiring additional financing, either through saving or newly issued debt.
In a final step towards realism lets introduce Keyne’s radical uncertainty, uncertainty rather than risk, what is unknown and unquantifiable about the future. Of course none ergodicity means that the future can never be like the past, all we have is evidence from past events about what the future is likely to be like. So lets assume we have a property, or any other type of asset bubble, but no one knows if it will pop this year or next or next decade, the evidence of history simply suggesting that prices of the asset will rise in the short term and collapse in the long term. If a bubble seems likely to pop it is rational therefore to increase estimation of risk and not to cease all altogether speculative investments but to adjust your portfolio and increase your hedging./ If you cease speculative investment altogether, unless your are preciant in your forecasting, you could lose altogether what alpha exists in the short run. With increasing risk, even if not wholly quantifiable there must be increased hedging and increased cost of hedging. In a market where asset prices continue to rise it is irrational to wait and undertake crusoe like savings – you lose out on a rising market, so demand for borrowing increases to finance the hedge costs. But that demand will push interest prices (the cost or money) up as banks or other lenders, now at the top of the market at maximum leverage of deposits must attract additional equity or loan funding (either forced by the market assessment of defulat risk or statutory deposit requirements if they exist). With interest rates rising the bubble may pop as the over leveraged default and credit dries up.
Note the key fact about this story. Note there is no irrational behaviour, it does not rely on Ponzi or speculative borrowers to use Minsky’s terms behaving irrationality, indeed all participants wisely hedge risks as much as they can given an uncertain future, and the more they wisely hedge the nearer the systemic crisis approaches. We are in the world of 2007 where despite massive hedging and covering of collateral financial collapse was not averted – indeed in the model presented here it is bright closer.
In this model there is no intermediation between the risk averse and the risk bearing, as with banking intermediation is not a function but an exposte rationalisation of net portfolio decisions. Some by the size and nature of their portfolios can afford to be greater risk takers than others but in this model all will rationally hedge these risks. In this model finance is from endogenous money and interest rates driven by demand and supply of liquid financing.
Seen from the perspective of the individual speculative or Ponzi financier their behaviour may bring thir own state of bankruptcy closer but not necessarily the state of breakdown closer, indeed in normal times bankruptcy is a good thing. Rather in the model presented here it is normal and well hedged financing which brings the breakdown closer regardless of the irrational behaviour of individuals, indeed the more ‘rational’ they are the quicker the breakdown comes. The instability fo capitalism comes not from foolishness it is endogenous.
We have been sympathetic critics of MMT on this blog, seeking to integrate some of its key insights with circuitism. Its basic insight, that a currency issuing country can spend before it taxes, is broadly correct – as state money is spent into existence. Also taxes net of state spending can equally destroy the purchasing power of money (we do not hold that taxes per-se destroy money – as Parguez, Seccarrecia and the ‘State in the Circuit’ theorists for example argue as – rather more subtlely that demand is altered by the net change in debt. So if a government spends less than the debts it writes down through tax raising then it reduces net effective demand and contra increases it – credit extinguished is purchasing power destroyed and vice versa.) This is an implication of the Steve Keen modification of Walras’s Law to incorporate changes in aggregate supply and demand through credit financed investment as first introduced at the MMT/Circuitist meeting last year. Though we accept that demand for taxes creates demand for currency we consider that this operates through the framework of credit based money – that is it is demand for credit that creates demand for money per-se as a store of value whereas taxes create demand for a particular currency as a unit of account. This is but a nuancing of the chartalist position and reflects historical cases where money has existed outside state monopoly currencies. Here we don’t really disagree with Randall Wray
we are not trying to claim that, um, taxes drive money, that that is necessary. It is merely sufficient. Taxes will drive a money. That’s a sufficient condition. Um, it’s perfectly conceivable – and people have many stories about this – of private entities creating a unit of account, denominating liabilities in that unit of account, and then exchanging those liabilities and using those in payment. It works pretty well in theory. It’s just that in practice we don’t find these. [rather I would say they are rare for example money in prison camps and the 18C Scottish banking system]
A final issue is that sectoral identities express accounting constraints but are not substitutes for a full monetary theory of production. So we would argue for example that ‘classical’ position (put most ably by Torrens) that demand itself will not lead to growth unless that demand is made effective through increased production of goods and services achieved through capital formation and accumulation. The purpose of state spending is to maintain that growth not per-se to increase money, indeed if the nominal purchasing power of money is decreased by credit creation by more than the growth in production then state money creation can harm price stability.
Within this framework it is difficult to reconcile neo-classical ideas such as a ‘state budget constraint’, ‘ricardian equivalence’ or ‘debt overhang’ (the latter might apply to the private sector but not to a sovereign currency issuer), but, in the post-Reinhart-Rogoff fallout (despite their ‘we are not really austerians ‘ post-hoc protestations in the NYT today) , does this leave any role at all for debt levels, particularly high public debt levels, in affecting economic growth?
So where does that leave the role of taxes? The MMT position is that taxes are used to control aggregate demand. (see Warren Mostler) This is correct though formally we would argue that there are dual channels. Firstly the writing down or creation of state debt based money is balanced by creation of private sector financial assets, taxes then can be used to net increase or decrease the money supply. For none-debt based money there is no accompanying financial asset so taxes in this case are necessary to directly rather than indirectly offset state money creation. But in the latter cases taxes would not be operating at the margin, so would have to be higher and this would suppress capital formation.
What then should the optimal rate of tax be? The optimal rate will need to be very different between debt based and none debt based state money regimes, according to the financial obligations the state sector owes to the private sector and between different real interest rates. If the real rate of interest is low then there is no effective difference, future debt obligations will be near zero. In these cases if there is a demand problem governments could create none debt based money to reflate demand and to take advantage to drive investment. The great disadvantage with this is the lack of a contractual obligation by the state to contract money later once the initial impulse from credit is spent, there is the political risk that taxes will not rise to deflate aggregate demand. The risk of debt free money is that the private sector could price in an inflation in the value of money and shift capital towards regimes with contractual obligations for debt repayment. Even in cases where interest rates remain low for a considerable period (as in Japan) there will be the considerable risks to the net inflow of state funds from an future upturn in interest rates which has seen an export of capital.
In cases where there are high real interest rates then future public debt servicing requirements will be high. To avoid the deflationary effects of paying down debt the state will need either to raise taxes – to maintain fiscal/demand neutrality, or further raise public debt, with implications for implied future deflation of demand. So we can see even in a world without a state budget constraint debt can be a problem if the change in debt impacts on future demand. The basic functional Lerner functional finance position which MMT inherits though is correct, growth in debt is manageable if outpaced by growth in the economy. In Keyne’s fundamental insight the ‘debt pays for itself’ if a boost to demand leads to a multiplier effect leading to increased tax revenues. Of course infinite growth in debt is impossible so there must be fiscal limits on the scope for such interventions without some form of debt write down.
As well as the impact of changes in debt there may also be impacts from the relative deficit levels. Public spending has a high local multiplier it is likely to be spent locally, whereas private investment in the local economy will see short term imports of capital goods and longer term benefits from exports. So austerity induced by high levels of public debt is likely to see capital outflows from those who receive interest payments to higher yielding markets without austerity induced stagnation. Indeed that is just what we have seen in Japan, where as Aziznomics correctly points out the private sector has now largely delevered leaving on high levels of public debt. Over the next few months graduate economometric students are likely to have a field day charting the relationship no longer only between public debt and growth but overall debt, private debt and changes to each under different initial conditions of growth and inflation. This is likely to be interesting but simply exposes the theoretical gaps we have in terms of the relationship between finance and debt.
Does old fashioned IS/LM help use here? No as the IS and LM curves only intersect at equilibrium and with high unemployment the labour market must be out of equilibrium and so must one or another of the other markets. as Hick’s stated in his late mea culpa it must be replaced by a disequilibriium understanding of the three way relationship of the money, labour and goods markets.
What then of the MMT solution to force the labour market back into equilibrium through an employment guarantee? Given the multiplier effects of public spending a rise in confidence could see capital repatriation and a rise in growth that would more than offset rises in future interest payments from the rise in debt. Indeed this is just what we have seen in the early months of Abenomics. Though prices are still declining now 3/4 of japanese consumers expect prices to rise. More radical measures could be tried to back an MMT inspired programme, for example a Central Bank could use its balance sheet expansions to invest in equity of firms that invest, hire workers and raise wages.
If then employment is forced back to a full employment equilibrium point the policy test is whether equilibrium can be restored between the goods and money markets. If there is still excess demand for money (hoarding) and ‘credit deadlock’ then the issue is how the holders of that money can be induced to spend it. Some ideas:
-A tax on idle balances used either to avoid austerity to fund interest on public debts;
-Cutting payroll taxes to zero and/or introducing a negative payroll tax (subsidy) to those at the bottom of the labour market;
-Shifting taxes to those things that will not deter capital formation and accumulation, such as land, &
-Directly monetising deficits/and or the central bank burning bonds it buys from state money creation. This would be inflationary but hey if you want to meet a minimum inflation target hey this is the way to do it.
This post was prompted by Tim Wortsall, of all peoples, post on whether progressive taxation makes sense a MMT world. In a sense he was right, and perhaps Randall Wray in response was not, the principles of taxation radically change in an MMT world as the overiding princple is how taxation can create inducements to restore full employment not how taxation can fairly fund public spending.
Hicks, J. (1982), Money, Interest and Wages, Collected Essays on Economic Theory, Oxford, Basil Blackwell.
Brett Fiebiger Modern Money Theory and the ‘Real-World’ Accounting of 1-1, The U.S. Treasury Does Not Spend as per a Bank
Scott Fullwiler, Stephanie Kelton & L. Randall WrayModern Money Theory: A Response To Critics
Brett Fiebiger A Rejoinder to “Modern Money Theory: A Response to Critics”
I have long argued on this blog that Steve Keen needs to be taken seriously as an economic theorist and he had made a number of contributions that help solve key theoretical puzzles.
I will posit that one of these contributions is a major modification, indeed correction of Walras’s law. But if he is to be taken seriously then we have to see what economic theory looks like with these changes ‘plugged in’ -does it become more or less coherent? Here I look at his correction of Walras’s law and its implications for general equilibrium theory, a track I wonder if Professor Keen is interested in going down as, rightly, he sees the rigid and dogmatic approach to equilibrium theory in the current lucasian hegemony in economics as a major weakness.
A brief recap, Walras’s law is that excess demand in all markets equals excess supply, they sum to zero, but if and only if an economy is in equilibrium. But the concept goes beyond this, for in disequilbrium, if there is an excess demand production rises, and an excess supply prices fall. The concept is tied to that of the market process achieving equilibriation of prices through equalisation of the rate of profit, a concept at the heart of economics since Tugot and Adam Smith. This is often overlooked. Because Walras started out his theoretical corpus with the very simplest of economies, a pure exchange one with magically assumed initial endowments, no investment, no production, no money, and no other factors of production such as land, and then built up his models to include production, investment and money. Today we see no end of papers with these crude modelling simplifications taken as given and the market process whereby equilibriation is achieved ignored.
Keens modification is that aggregate demand (or as he would term it effective demand) must also add change in debt plus net asset turnover. The first of these is the equivalent of Schumpeter’s ’newly issued credit’ and embodies an endogenous theory of money and growth, common to Schumpeter, Marx and Minsky. The second addition relating to net asset turnover is a more subtle one, at first sight it seems that net value of assets sold cancels out but this is an equivalent fallacy to that stating debt values and financial asset values cancel out, which ignores the passage of time and that debt is a stock, wheras the value of the asset is the capitalization of a flow. We can see this with Marc Lavoie’s critique of an earlier version of the modification.
if I get one million dollars in loans to purchase a house, credit goes up by one million; and if the seller of the house puts the proceeds in a bank account, this will have no effect whatsoever on GDP or economic activity. It may only have an impact on the price of houses.
Three responses to this:
1) What if the loan is used to purchase a newly built house? Then there is certainly a net increase in economic activity. Here we can see the power of the Schumpeterian approach because without that credit the house would not have been built and neither the increase in economic activity. Of course a new financial asset will be created which will cause transfer payments between creditors and debtors in the future and may equally depress effective demand if that money is retained in idle balances and the economy has not grown in the interim;
2) Growth in bank accounts do have an effect on economic activity if it leads to an increase in excess reserves which banks try to offset by increasing lending. Capital plus excess reserves is the banks budget constraint (we have covered this point, and the fallacy that reserves don’t matter in endogenous money theory, on this blog many times, and we are agreement here with all of the banking theory textbooks written from an endogenous money perspective). Of course if banks do not lend we get a seizing up of the monetary circuit.
3) What if there is a shortage of new housebuilding relative to the growth in credit? Then Lavoie is right house prices will rise. Though this then triggers the market process of equilibriation, if profits in the housebuilding sector are higher than the general rate of profit there will be new entrants and prices will fall, however because housebuilding takes a long time in the interim there is likely to be speculation and an unsustainable increase in prices.
Keen’s theory has received a boost from his collaboration with the Field’s Institute and the resolution of the apparent inconsistency of the formula with Keynesian ex-poste accounting identities. Im sure in time this modification of Walras’s law will be recognised as sound and correct. But if Keen is right what does it mean for equilibrium theory?
Money was a central component of later versions of Walras’s grand scheme. Walras elaborated the Say conception of entrpreprenuers being the intermediating parties between production and consumption, a view later taken up with relish by Schumpeter. Unlike the artifice of a pure barter economy you cannot exchange a good for a good that has not yet been produced, as circuitists would argue you need an intermediato ( a lender), hence money. Though banking was no direct part of Walras’s scheme he, at the same time as Jevons and in anticipation of Fisher, saw the passage of time through investment as money, the capitalitalisation of the capital good returns (after amortization, depreciation and insurance) creating the value of money, the market then between competing capitals equalising the rate of profit through the equity and money markets simultaneously with all other markets.
It is too easy to see in Walras’s initial models of a pure exchange economy a foundation stone of neoclassicism. This happened but put neoclassicism on shaky foundations. It is better I think to see Walras’s overall project, as Schumpeter did, as completing the classical project through the addition of a theory of price, and this link is even clearer in slightly later models of equilibrium that did without a pure exchange economy preliminary such as from Von Nuemann, Wald and Cassell. After all the simultaneous equation approach towards rate of profit equalisation was not new, Walras knew of Isnard’s earlier work, though he did not know of Edward West’s and Colonel Torrens’ use of the simultaneous equation/reproduction schema approach in correcting the classical theory of value (a strand later taken up by Marx and Sraffa). Also the ‘time as value’ approach had also become embedded within classical economics as the ‘waiting/cost’ theory of interest, though that theory was incomplete ( I write on and defend this theory here).
Walras’s approach to money though was complex and incomplete. In his early writings he introduction the duex ex machina of the quantity identity to solve his system, opening him up to the Patinkin criticism that the market for money was treated differently from all other markets whereas the supply and demand for money should be treated on the same level. In later editions Walras did attempt to model money simultaneously though iut was never fully resolved in his lifetime. Also by posing his simplest systems as ‘static’ he like Marshall created the shibbolith of ‘comparative statics’ two systems in equilibrium with a ‘transition’ between. The concept of an intertemporal equilibrium created by the capital markets was always implicit in Walras’s dynamic models though never fully worked up till later theorists in the 20s and 30s
Walras to recap held the Say position that entrepreneurs provided the equilibriating market discovery process, though to fit this to the simultaneous equation approach he was forced to adopt the fantastical ’tatonment’ process where nothing is bought or sold until equilibrium is achieved. It was Schumpeter who discovered that although the market process was equilibriating between markets it was initially disequilibrating within a market and in the capital market, and indeed it was on this basis that entrepreneurial profit was based rather than immediately being absorbed as quasi rents (see here on the profits puzzle).
Walras never fully developed a theory of growth, though from Schumpeter we can add the credit induced creation of improved production techniques and this inducing disequilibrium followed by equilbriation. Of course since the market process is going on simultaneously in all markets we may ever reach a state of intemporal equilibrium, like the equivalent and more robust classical case of the ‘long run’ it is a tendency not a moment.
So enter into this Keens elaboration of Walras’s law. It is helpful because it helps bridge the missing full dynamic, monetary and evolutionary aspects to growth that Schumpeter mapped out but never mathematically set down.
If we have an excess demand on one side of the Walras-Schumpeter equation from credit growth we have simultaneously disequilibrium (excess supply not yet produced) now leading to a price shift and change in production schedules, and intertemporal equilibriation as investment creates new capital from that credit growth. All this assumes that credit is not malinvested, if it is then the new production techniques and shift in pricing schedules that results will not be sustainable. Those processes only marginally profitable at higher rates of profit will be withdrawn and the labour associated with it typically laid off. With the reduced effective demand from purchasing power the economy may then shift into a new partial equilibrium state at near permanent high unemployment This excess supply of labour/reserve army of unemployment is an excess supply awaiting new entrepreneurial activities to exploit it and bring back towards general equilibrium; but without credit or demand it will be a slow, slow process with no guarantee of success in the harshest of capitalist crises.
To me then the Keen elaboration of Walras is a way of making sense of Walras and enabling a truly dynamic non-lucasian post Keynesian view of growth and economic change free of stultifying neo-classical comparative static chains and with money and the financial sector endogenous Indeed I like to think of it as how classical economics might have evolved if it had got its maths and accounting identities right. Indeed I would urge the Fields Institute to check out what equilibrium theory (especially of the Von Nuemann form) looks like with this correction. Readers may also wish to think about the implications for capital theory.
In a speech today Teresa May claimed
One area in which we can be certain mass immigration has an effect is housing.
“More than one third of all new housing demand in Britain is caused by immigration.
And there is evidence that without the demand caused by mass immigration, house prices could be 10 per cent lower over a 20 year period.”
She also said in future the impact of immigration on house prices would be included in government impact assessments.
Evidence by Professor Stephen Nickell to the House of Lords Select Committee on Immigration in 2008. Para 171. when he was chair of the NHPAU which of course the government has now abolished. We don’t know the source but we can imagine it was the defunct NHPAU model, so how the government intends to incorporate this into impact assessments in the future without any model I don’t know.
Of course it is meaningless talking about house prices on the demand curve side of things without talking about the supply curve and the impact that immigration has had on lowering housebuilding and renovation costs, as well as the impact on GDP / head it has which of course makes housing affordable in the first instance. The same report concluded that immigration enlarged the economy as a whole but the impact on GDP/head was small for the existing population but large for the immigrant population.
I hope Teresa May has learnt the lesson from the US on the success a vote for us if your native and we close off opportunities for members of your family if your not had at the last election , and how it will have more and more negative impact over time. It is hard to imagine too how a future conservative majority can be secured without a big win in London, which from the census we now know is majority non-white. The path to victory for the conservatives lies not with the paloeconservative policies of May but with those of Boris Johnson.
A small point but Professor Nickell’s evidence was not looking at the impact of mass immigatation but the hypothetical impact of no immigration at all, no one outside UKIP or BNP
If you have missed it Pontus Renhdal has responded to my notes on his critique of Steve Keen and I have replied.
There is something the entire SFC modelling community knows it needs to do – but it is hard and not yet done meaningfully to my knowledge.
That is to model insolvency and bankruptcy.
Its hard because for sake of simplicity models are simply aggregates of the whole firm sector – not quite as bad as a single ‘representative firm’ but not far off.
Seemingly modelling interactions between firms involves modelling of agents and network effects between agents – this, with the aid in advances in Graph Theory is a fecund area of study- but it adds a whole extra tier of complexity to models. Is there a way to cut through this and capture the impacts of liquidation at a higher degree of aggregation?
This is important because it appears that the key difference between a ‘normal’ (if their is such a thing) recession and a balance sheet recession is the degree of insolvency caused by the inability to repay debt. In a normal recession profits are depressed but proportionately few firms or individuals go bankrupt, most balance sheets remains in the black, and the economy quickly bounces back. In a balance sheet recession on the other hand as one firm goes bankrupt it creates bills that remain unpaid in other firms, potentially triggering a wave of bankruptcies and unemployment and a ‘death spiral’ fall in effective demand.
The Krugmanesque concept that creditors=debtors=so what is deflated because (and there are many other reasons) bankrupt firms by definition cant pay their debts.
There is a clue from accountancy as to how to treat valuation of insolvent firms as opposed to solvent firms which I think can cut through this complexity and enable simple aggregate modelling. So far it is just a hunch but I thought I would share it as it is closely related to the thinking I have presented here on the solution to the ‘profits puzzle’.
First some definitions.
Insolvency is not the same as Bankruptcy.
Insolvency is the inability of a firm to pay its liabilities (the Wikipedia definition of inability to pay debts I think is imprecise).
Bankruptcy is the juridical recognition of insolvency. As in most jurisdictions it is illegal for most firms to trade whilst insolvent so unless false accounting is involved (which it often is) then bankruptcy will quickly follow.
The matter is complicated because their are stock and flow aspects to insolvency.
A firm is flow insolvent when its cash flow of revenues plus any reserves of equity/retained profits which provide working capital is insufficient to cover its liabilities (all debts including mercantile credit) and reserves of equity which provide working capital to the firm.
A firm is stock insolvent when its liabilities are not covered by its assets + equity.
Both of the above can be expressed precisely using the fundamental equation of accounting.
I refer to liabilities rather than debts to refer as well as bank credit (which create money) mercantile credit (and almost all commercial transactions of any scale are invoiced). Bank credit is endogenous creation of money, mercantile credit is the increased turnover of existing money (what classically was called fully covered credit) through maturity transformation between firms with strong cash flows and those without. This has become more complicated in recent years in that firms themselves are now issuing financial products which for all intents and purposes is endogenous money creation; though these products are not always fully liquid. But none the less the broad distinction between bank credit and fully covered credit (or Robinson Crusoe type savings if you are of Austrian persuasion) remains.
The fact that both stock and flow insolvency are covered by the same term is confusing. Increasingly legal systems have come to recognise that firms can be restructured by selling assets and cutting costs and still remain as going concerns with positive future cash-flow. Hence in America with have chapter 7 bankruptcy and scholars sometimes refer to the ‘end of bankruptcy’, by which they mean that flow insolvency alone is not sufficient to force closure of a firm unless the firm falls prey to an asset stripper.
The language of central banking has also evolved. We often hear that ‘banks face a crisis of solvency and not liquidity’ by which they mean that banks are stock insolvent not just flow insolvent and that an addition of equity is required.
Ok lets model this using the fundamental accounting equation
(1) Assets-Liabilities =Owners Equity, or in shorthand A-L=OE
We may represent stock insolvency, or better viability insolvency as we may better term it by the following inequality:
Whereas flow insolvency, or perhaps better liquidity insolvency can be defined as follows
The valuation of a firm that is bankrupt is quite different from that of one that is a going concern and that I think is the key.
The valuation of a firm as a going concerns involves addition of the value of goodwill. The valuation of a firm for break up purposes cannot include goodwill because there will no firm going forward. As we have blogged before the correct treatment of goodwill is critical to understanding the ‘profits puzzle’ of economics. If a firm is exclusively making profits from assets which are alienable (salable) then it might as well be bankrupt because these same assets can be rented by anyone else- which are simple transfer payments between segments of the economy. If a firm is to generate growth it has to generate value in the firms equity value over and above the firms asset value – goodwill – the franchise value of the firm. This valuation like that of any other factor (and the solution is to treat equity in franchise value as a factor) will have a factor return, and opportunity cost to keep that factor in production (which in cash terms is imply the average rate of profit in the economy) and a rental factor dependent on the scarcity value that the firm creates – or put another way the degree of oligopoly in the market or markets the firms operates. We showed in our previous post that the factor income due to equity ownership of franchise value is equal to Total Factor Productivity or the Solow Residual, its that simple.
So economic growth is equivalent to the creation of franchise value by firms, recession is equivalent to its destruction. This concept goes beyond the crude concept of ‘capital destruction’ as it avoids capital theory fallacies by carefully separating out factor returns and rents from all factors including fixed capital land rents, money rents (interest) and equity in franchise value.
So when a firm goes bankrupt its future goodwill generating capacity is zero and the firms value is solely that of alienable tangible assets.
Or put more formally:
For a solvent firm its valuation is. This is of course simplistic and assume that the owners equity portion is clearly identifiable and attracts a market price, and that similarly future cash flows and liabilities of a firm can be forecast (which does not mean that they can be forecast accurately).
If a firm is profitable it attracts a positive valuation, if not viable equity must be written off, assets sold and the asset owners matched to the liabilities must take a haircut.
As with our profits formula we can split a positive valuation into two. That resulting from its ownership of alienable assets and once from the franchise value of its equity (goodwill). As follows
(5) Going Concern Valuation=discounted cash flow stream of Franchise value+Asset Value-Liabilities
(6) Break Up Valuation =discounted cash flow stream of Asset Value-Liabilities
Subtracting 5 from 6 we have
(7) Rate of change of negative growth from bankruptcy =ΔGoodwill
So in aggregate terms ‘all’ we need to do to model the impact of bankruptcy is add a factor for goodwill aggregated in the economy as a whole.
Now you might say that this is by definition true as an accounting identity and hardly worth saying. But the lesson of the whole post-Keynesian project is that things are never too obvious not to state.
Modelling the rate of change of goodwill is easier said than done. It requires I believe a reproduction model of different sectors of the economy (rent seeking and productive) and an accurate breakdown of cashflows for each of the five factors. But, and this is the key, it can be done without the full complexities of agent based modelling. This may require an probability density function for firms of different levels of profit (and hence equity valuations) and an algorithmic to value firms differently with negative (viability insolvency) balance sheets, but it is possible and critically may be possible with most off the shelf SFC modelling packages.
Deavid Cameron in a CBI speech today will claim an explosion in JR cases. But this is deliberately misleading as it does not make it clear that this is for all cases not just planning cases.
11,000 applications for judicial review were made in 2011, compared to just 160 in 1975.
In headline terms there has been a dramatic increase. In 2011 11,200 applications for permission were received. A decade earlier, in 2001, there were only 4,732. However the significant increase has been concentrated in only one type of case. The statistics divide the applications received into three categories: immigration/asylum; criminal; and, “other”. The growth has been in the immigration/asylum category, which has risen from half of the total number of applications in 2001 to over three quarters in 2011. What does this tell us? Simply that, outside the immigration/asylum arena, there has been no explosion of judicial review cases at all but rather a very modest increase – during the decade the total figures for “other” have ranged between a low of 1,685 applications in 2004 to a high of 2,228 in 2006 and with a 2011 figure of 2,213.
Of course in Immigration and Asylum cases the rights to JR on procedural grounds has already been removed, but because JR on ulra vires grounds cannot be removed and because ministers make policy decisions to ignore certain european and british caselaw JR explodes.
Even for those of use that support some modest planning JR restriction this is the worst possible way to make the case. The argument will be torn limb from limb on Newsnight and Today and the ‘crossing every i and t’ ‘economic equivalent of War’ quotes will paint a picture of a PM with an omnishambolic grasp of statistics Neville Chamberlain like out of his depth. This is entirely a slow motion car crash of number 10s own making.
In a consistent [circular] flow conception, the total value of factor inputs must equal the total value of output at nominal prices, so that aggregate profit accruing to entrepreneurs must be zero. The same should be true of interest paid by entrepreneurs. Moreover, if all revenues accrue to owners of production factors, no monetary resources should be left for fresh investment leading to economic expansion…if the economy is indeed a circular flow, how can there also be profit-oriented entrepreneurship, interest, and economic growth?(Bezemer 2010)
Profit is the fundamental driver of capitalism but its explanation has seemed mysterious and puzzling. It was a problem that has fascinated Schumpeter, Marx and Keynes all of which came close to but never fully arrived at a satisfactory solution. Wagner’s view (recounted in (Graeber 2010)) that grail mythologies reflect the hunt for a mysterious and intangible force of wealth creation recognised at the origin of modern mercantile capitalism, seems to sum up the intellectual approach towards the concept. Mythological, a puzzle, for in both neo-classical and post Keynesian approaches it should not exist at all, at least in the short run and under idealised conditions, but even when the unrealism of those idealised assumptions are relaxed then profit should not exist in the long run, suggesting that it is only a residual resulting from asymmetry of information, ignorance, to be hunted down and eliminated once that ignorance is banished by competition. Profit though does not result from the absence of something but from the positive presence of certain conditions. It is real though not necessarily tangible. No we have not been dreaming profits exist and theory can simply explain the profits puzzle. In recent years there have been considerable strides to solve the puzzle, especially from circuitist thinkers, accountancy theory and from growth theory, but these have not yet pinned down the exact solution, its monetary, real and value relationship components, which I tentatively submit has a surprisingly simple solution.
1. The Neoclassical Approach – Defining Profits and Growth Away
The well-known thesis is that under ‘perfect competition’ profits cannot exist. Under a series of very strict conditions including no barriers for entry, no differentiated products, perfect flow of information etc. there is no scope for profit. An uncountably infinite number of producers are pure price takers. None can raise prices to create a profit because they would be instantly bid down. In recent years the mathematical assumptions behind the model have come under criticism. However even if you individually relax the key (none real world) assumptions, such as over differentiated products for example, then this means one of either two things, firstly there is no long run profits as the creation of profits attracts competitors and profits are again asymptotic to zero, or, the alternative case, there are no profits other than from degree of oligopoly, the ability of the seller to be a price maker rather than a price taker (Schumpeter 1934). The latter may be an explanation of rents but it is not an explanation of profits deriving from means other than rent (within the term rent I am including Marshallian quasi-rents from production from fixed assets with sunk costs because as Sraffa stressed their returns can be treated exactly as rent). Even money can be rented (interest). Any alienable factor can be rented if it has scarcity value which can add value in production. So in the neo-classical model of the firm, even if the strict assumptions of perfect competition are relaxed, there cannot be an inalienable source of profit, factor income, attributable to the actions of the firm, which cannot be rented from another agent. (note: I use factor income to refer to the income stream from ownership of a factor which may be over and above the level of factor returns necessary to keep that factor in its current use, i.e. it may earn a rent. Of course in the neoclassical perfect competition story this factor return can be any level infitessimably small above zero as all profits are pushed to zero). All factors incomes are exhausted, profits are zero. The neoclassical story is that of a single product market, there is no market for firms: equity markets. The tendency to zero profits is quite different from the classical assumption that profits rates tend to an average rate. Neoclassical theory assumes a rate of ‘normal profits’ sufficient to attract investment into an industry, but even if we introduce an equity market where investment does not take place where projected returns are below the average rate, then profits attract competition which drives profits back towards zero. The neoclassical approach in assuming a base case of perfect competition and equilibrium where ‘normal’ profits, within the confines of the theory, either are impossible or are driven towards zero. A theory that cannot explain profits or economic growth is a useless theory of capitalism. There has been a recognition of the problem in recent years with the attempts at ‘endogenous’ growth theory, but the result a mysterious ‘total factor productivity’ an unexplained residual (the Solow Residual) independent of individual factors simply again stresses the ‘puzzle’ of the source of profits and is incompatible with the assumptions of perfect competition which underlie general equilibrium theory. In neoclassical theory we can either have messy and real economic growth, or the perfection of general equilibrium, but not both.
(note 1: There is a flaw in the Okishio theorem that no capitalist ever rationally introduces a cost saving technique which causes the industry rate of profit to fall, and so there can be no tendency for the rate of profit to fall. It does not deal with sunk costs of durable capital and multiple investors making decisions about investing in such capital at the same time without full awareness of each other’s actions. In these cases the investment may or may not raise the rate of profit in the short term but once firms have to price at marginal rates when costs are sunk the average rate of profit across an industry will slump – as it did for example with railways once debts of initial fixed costs were fully amortized (amortized and depreciated in value terms that is not necessarily physically worn out). This is not to necessarily endorse the Marxian Theory of the Falling Rate of Profit, but simply to stress that without countervailing tendencies which I shall attempt to express, or massive write off of durable capital, one of the key drivers is a tendency to fall. Marx’s writings on this subject in Capital III are often characterised as ‘underconsumptionist’ and in that vein are flawed as they don’t account fully for capitalist consumption goods spending, as many early critics realised. However my reading is that this is expressed as a realisation problem long term and structurally, quite different from his shorter term theories of the business cycle, and here he may have been on to something) (note 2: By average rate of profit I do not assume a mean of all rates. Many firms will be making losses or have very low profit rates. It is projections of future profits that investors consider and industries with limited prospects will be disregarded as not investment candidates. The average rate is largely unobservable).
2. The Post Keynesian ‘Naive Surplus’ Approach
In the Post-Keynesian ‘surplus’ approach you take each factor of production, capital – fixed and circulating, labour, land – the discounted value of each is the cost of production (rent of money being itself a factor as later writers in the classical tradition understood – see our reconstruction of the waiting theory of interest here) – add them up, you then get total cost, add a profit markup to get price, and revenues minus costs is the surplus minus profits. I still hold to this broad construction but there is a problem, it was seeing the surplus as being ‘left over’ – the absence of something (costs) rather than being positively created by some economic cause. You can describe a mathematical formula where profits are a residual: Revenue-Costs=Profit. It would be formally correct, but is a necessary but not sufficient condition for the existence of profits. The following values would satisfy the formula but we have no profit 0-0=0. You might protest that this is the definition of a non-economic event. No production, no distribution. But what then is an economic event, I would say actions which aim to create profit? Here a Marxian with M-C-M’ and an Austrian agree, and neo-classicals often flounder, the identification of a profit making activity is a positive act that is the commencement of the capitalistic process. So enterprise is not just the absence of something (cost) ‘left over’, it is the enterprise of retention, after costs, of a positively identified revenue raising activity. Consequently we might rewrite the formula as follows: Identified Revenue Raising Activity-Costs=Profit. This is why I refer to the naïve’ surplus view, like the naïve productivity theory of interest mere productivity, or physical surplus, does not by itself guarantee value capture, that must be secured and realised.
3. Circuitism: An Insoluable Problem?
One of the key post-war contributions to Post Keynisan thinking has been French and Italian Circuitism. But in parallels to the neo-classical story profits are again defined out of existence. This was a particular theme in early Circuitist writings.
As various writers have pointed out … the account of the Monetary Circuit…leaves no room for the payment of interest in monetary form… all of the money issued in the production loan contract is spent as wages and then exchanged for production, held as deposits or used to purchase [financial assets]. There is no additional money with which to pay interest. … on the face of it there is no way of converting [the physical surplus from production] into money, since the firm cannot acquire more money from sales than it pays its workers. Since the only money existing in the market is the money that banks have lent to the firms they can only repay in money the principal and are unable to pay interest. … Some circuitists such as (Bossone 2001) and (Schmitt 1966) regard the interest problem as insoluble (Weir 2009)
With the assumption that the only ‘solution’ is ever increasing borrowing and ever increasing debt. For (Graziani 2003) for example the firm sector as a whole cannot make profits and debts must continually be rolled over.
In other words a ‘gap’ theory similar to Douglas and many ‘monetary cranks’ before (although like Keynes I do not necessarily regard the term as an insult if a flawed theory gives wider insights)..
A closely related problem, from Basil Moore, is the view that from the S=I savings=investment identity the monetary value of investment ex ante cannot be greater than the monetary value of savings ex poste. From this position it has been argued that credit cannot fulfil the role of bridging any gap between demand before and after production, an increase in demand necessary to both pay for the goods produced and interest on the loan.
These approaches represent fundamental misunderstandings of the role of interest, how that is accounted for and how interest recirculates through the economy. A naive circuitism also. In the last decade there have been great strides by writers sympathetic to the circuitist position to clear matters up; almost but not quite.
Most of the suggested circuitist solutions rely on the passage of time, that the world is quantitatively and qualitatively different after an injection of investment, and consumption logically following production. (Gnos 2006) for example relays on overlapping time periods. (Parguez 2004), and (Nell 2004) argue that because capital goods paid for generally before wages, any money spent by firms on goods purchased from other firms is returned to the firms sector via wages of the employees of capital goods firms and so is then available to repay debts. (Seccareccia 1996) argues that because of this recirculation bank loans include the money to pay out interest and profits.
Although there are (mostly) minor variations in the wiring of such explanations of the circuit all rely on that much neglected component of production – turnover. As all monies spent in production may be respent by workers in those industries and of intermediate goods suppliers before the final realisation of profit through the sale and consumption of the final consumer good. (Note: I do not accept here the Austrian concept of ‘average period of production’ where this period is a measure of capital intensity. This fails on capital theory grounds, in particular the arguments stressed by Kaldor. However a lengthening of the production period does provide greater opportunities for turnover of wages. The false Austrian approach is a failure of dimensionality where time, as in their interest rate and capital theories is a reification, a thing in itself, rather than simply the ordering of past physical events)
4. Towards a Possible Solution
I start with a number of assumptions.
a) Assume a world where profits exist rather than where definitionally they do not.
b) Interest can (in certain cases) add to the cost of production and hence the post-Keynesian ‘normal price’ of goods.
c) Interest is not the same as profit (though the two are closely related), interest is a discount on any other factor of production and in this manner money (in its commodity form) acts as a unique factor of production; the only factor which is a charge on all other factors by the holders of scarce money.
d) Production takes time. Profitability has a maturity gap requiring credit to fill. Profitable processes create value over time. Interest can capture some of that value to holders of mature liquid monetary assets.
e) Charged interest held in reserves and then invested or spent completes the monetary circuit through reflux. Providing (partially after Bentham) new money is used for consumption and production (in balanced reproduction) and not asset speculation then its recirculation and increased turnover will generate the money demand to pay interest through overlapping borrowing and spending in many markets at the same time.
f) Where production is profitable and money is injected then saving ex-poste will be greater than investment ex-ante through application of the Khan/Keynes multiplier effect. Demand driven growth (I will deal with supply driven growth in the next part).
g) One firm will be more profitable than another to the extent that either it owns factors which secure a rent (in which case they are transfer payments that do not add to growth), or, if it owns no such factors then profit must be due to a ‘missing factor’ a surplus of revenues from that factor above its costs – which does add to economic growth.
h) If a firm itself owns the cost element of this ‘missing factor’ it can raise its profits by the rate of profit it would otherwise have to pay for this cost to others.
Note on a) There are two issues here, money like any commodity factor, has an element which is price taking, the factor return necessary to secure it in production in that investment; and a rental element dependent on its relative scarcity and the ability to transfer income from profits between factor owners. Such rents have extensive and intensive margins – the first of which adds to cost but not relative cost, the second of which is a price making element which raises the necessary factor return. The second is that like any factor it only contributes to short run prices where a firm is profitable, otherwise price of goods in inventory has to maximise revenue to minimise losses (see (Machlup 1935)), it is only in the long run that costs are adjusted to the point of maximum revenue through imputation – this applies whether there is a strong degree of competition or oligopoly, the only difference being that oligopolies being more profitable are in a stronger position to be price makers than price takers. (Matchups’ view that interest on sunk capital does not add to cost is flawed if you assume that interest is part of the initial cost, as then the cost is not sunk until both premium and interest have been repaid.)
Note on b) Capital is not a single undifferentiated ‘thing’ like Knight’s Crusonia tree, Profits is not the same as a ‘factor return’ on capital, a capitalist might not even own his fixed capital, it could be rented, and yet the capitalist might make a far greater return, in using the rented capital, then the owner of the item of capital does. That is the explanation for the additional value? Similarly a capitalist might not even own his or her own start up capital, they might take a loan, and the interest applies to the discounting of all factor costs during the period of production, so what ‘factor’ is owning the additional value which creates profit?
Note on e)The solution proposed by Bezemer and Thommassen (Bezemer 2010) is unsatisfactory. They suggest that credit for productive purposes (after Schumpeter) provides the monetary source for investment, whilst credit for consumption (inspired by Bentham) provides the source for profits. This is for several reasons. Firstly it unsatisfactory because it is only necessary to seek a source for profits outside investment if after fully accounting for all factor incomes there is a gap. Our analysis (below) suggests there is no gap and that prices of production already take into account interest costs (discounting). Secondly they raise the important question of reproduction, the relative rate of growth of production and consumption credit is a critical issue for the business cycle and relative prices, and whether prices reflect fundamentals, but it does not explain the source of profit, which is not simply a question of the source of money in the circuit as such money must be invested/consumed in a sector attracting profits. It is therefore primarily a question of valorisation/realisation. Take a simple thought experiment of a pure credit economy where there was no production credit only consumption credit, and therefore investment must be financed by Crusoe type savings. Aggregate demand would be attracted to a new product/service and demand would be drawn away from other products/services partially be displaced demand and partially through depression of aggregate demand through savings to invest in the new sector. There would be a relative price rise in the new sector which may lead to speculation and eventual erosion of profits. But the Benthamite approach cannot explain three things; firstly what is the source of profit in the new product/service before any new credit is granted, secondly how can expansion of consumer credit be the source of profits if in raising prices it induces intermediate goods producers to raise their prices leading prices back to rather than above the average rate of profit, finally, how can it explain the source of profits if in causing prices to rise above fundamentals it lowers not raises profits? The authors also undermine their own theory ‘there is no evidence that profit levels vary systematically with (capitalist or otherwise) consumption levels, not even in the long run.’
So far the tentative circuitist solutions and dealt with a-f, explaining how the money for profits and interest is created, flows and is reproduced. They have done this rather well, it is much less of a puzzle. If there is a positive time interval between issuing of the initial loan and the payment of the final wage and/or a positive time-interval between the first instalment of sales receipts and the last of any particular circuit, then a firm can pay interest to the bank in the form of money, receive it once more in money, use it again to pay its suppliers, and so use it to repay its loan in the usual way. This is a particular feature of the model of (Chapman 2006 ) where the continuous payment of interest, which immediately adds to what we have termed (after pre-neoclassical banking theory) ‘lending power’, which in later writings Keen explains as an intangible asset which creates the ability of a bank to lend, and is relent before production is completed. With recent work with the Fields Institute Keen has to many satisfactorily reconciled the accounting identity approach with that of credit injections acting as a discontinuous addition to aggregate demand, though there are still holdouts.
What these various writers have not explained is g to h above, what is the cause of profits and growth within the firm if factor incomes sum to price? They help explain the monetary source of profits, but don’t explain how profit is possible in value terms if factor incomes sum to price.
One can rightly suppose that firms borrow money from the banks and spend in advance the profits they expect to make. But this is not sufficient to solve the problem under discussion: being anticipated, the formation of profits is not explained but presupposed. (Gnos 2003, p333)
I won’t go through the solutions offered in detail, good summaries are provided by (Weir 2009). A key breakthrough worth highlighting though was by (Zezza 2004) which has inspired much subsequent stock/flow modelling of the monetary circuit, who stressed how much previous modelling of the circuit did not account for bank profits from interest payments The business model of banking of course is of banks making a profit on lending through borrowing short and lending long, their ability to do so depending on an intangible asset, lending power. What clue does this insight give us to profits in the none banking sector?
Put more broadly what then is this mysterious ‘missing factor’ and who benefits from it distributionally?
5. The Missing Factor – The Franchise Value of Equity
‘How can it be that we are wealthier today than people were 100 years ago?. . . This question is puzzling because, if you add up all the things we own, it is clear that the underlying quantity of raw materials has not changed over time,. … The total physical mass here on earth is the same as it has ever been, and now we have to divide this up among a much larger group of people. So how could it be that we have more total wealth per person than we ever did before? …There’s only one explanation for this increase in wealth. We took this raw material that was available to us and rearranged it in ways that made it more valuable. We took stuff that was not very valuable and made it much more valuable. … What lies underneath this process of rearrangement are instructions, formulas, recipes, methods of doing things – the things accountants classify as intangible assets if they recognize them at all. They tell us how to take something that is not very valuable and rearrange it into a new configuration that is more valuable.’ (Evans 1998)
Two lines of investigation led me to the conclusion presented here.
Firstly the theme on this blog of investigating the separate factor income flows (the four factor model – including money as a factor) was given additional impetus by coming across (Hobson 1910) ‘The Industrial System’. Hobson is best remembered as being both a pioneer of the marginal productivity theory of distribution and also its fiercest critique. Hobson splits up factor costs. The cost of keeping a factor employed in production and over and above this the ability of a factor to collect rent because of its scarcity value caused by the ownership of economic resources. Land rent (differential rent) falling wholly into the latter category. The approach is not altogether fully coherent and is not precisely mathematically defined, but key to his approach was the insight that a ‘residual’ approach towards profits, was untenable. The residual approach, this was well before (Sraffa 1960) wrote, was promoted by Taussig in seeking to retain key Ricardian elements in economics. After rent and costs of fixed and circulating capital were deducted a business had to meet the average rate of profit to attract further capital and stay in business in the long term. What was left over was wages. Hobson argued that this approach had logical flaws as all factor and output prices were determined simultaneously. You could take any of the factors in turn and leave one as last and then it becomes a residual. Also it does not explain why certain forms of labour earn more than others.
Given the importance that circuitist writers lay on wages being paid ex ante before revenues and profits are realised it untenable to treat profits as a surplus paid ex poste together with wages. Also Sraffa himself was uncomfortable with this, only giving up on ex ante payments after hitting a mathematical brick wall. Ex ante wage payments only make sense where the output good is the same as the wages good (as in a corn economy).
The second strand of inspiration was the line of investigation initiated by Neil Smith and taken up by Steve Keen that the power of bank lending results from an intangible asset held by banks. Our further investigation using the fundamental equation of accounting showed a flaw. This lending power came from nowhere, the fundamental equation suggested it had to come from equity. Furthermore similar investigations showed that this intangible asset that generates the ability to lend and profit from lending could be enhanced by undistributed profits – Keynes ‘revolving fund of credit’.
This begged a question. Could this explanation of the business model of banking also explain profits in other sectors? Finding the source of the ‘missing factor’ was key in the history of theories of interest rates. Perhaps there was a 5th factor specific to the firm? By using a Hobson like approach distinguishing between factor rents and factor returns could we distinguish profit sources from the ownership by the firm of assets which generate factor profit streams and profits generated by an intangible asset which is specific to the firm?
We can therefore define profits, form the perspective of an individual firms as follows:
- Π=( Factor Revenues[rental+factor returns]-Factor Costs)+(Franchise Value Revenues[rental+factor return]-Franchise Value Costs)
Where the capitalised Franchise Value Revenues is value of equity in the firm not attributable to alienable assets that if rented rather than owned would not make it possible for a firm to continue in operation.
To paraphrase (Greenwood 2006) firms purchase working capital by selling stock; they rent it by issuing debt. Debt owners however have no claim on profits once the investment the debt finances is sunk, so debt financiers are denied a longer term income stream of rents from franchise value. Equity buyers will therefore pay a premium over debt financing potentially leading to excessive issuance of debt.
Notes: By Franchise Value I refer to the full value of the intangible assets of the firm. Brand, business processes, IP etc. Many of these like R&D, marketing etc. will have an associated cost to maintain. Franchise value refers to the potential alienation of the firms business methods as a rented franchise whether actually alienated or not. The price here is the price of equity. Franchising per-se may not always be practical, though in some cases it may offer a quicker route to expansion, especially where franchises don’t directly compete in the same market. In other cases where intangible assets relate to a firms size and institutional knowledge franchising may be highly undesirable. Franchise value belongs to the firm. In many cases though the cost of maintaining franchise value will be relatively low, simply the act of the entrepreneur in running the business. In which case the owners of the business will generate large rents from the returns to the factor being greater than the costs necessary to retain that factor in production.
Other factors in a competitive market will have their factor incomes driven down to the opportunity cost of the next best return, which in a hypothetical perfect competition world would be zero. In the real world there would be a degree of scarcity of these resources so they would return an oligopoly rent, which would be a pure transfer from other factor incomes, it would not create growth or be required to maintain that factor in production. The factor return of franchise value however can create economic growth rather than rentier extraction of income. It does this in one of three ways, firstly by transfer of allegiance from an alternative product to that of the firms, this is not a pure transfer payment as the velocity of money is increased, this is subject to diminishing returns however as velocity approaches zero and the costs of advertising etc. to secure brand transfer rise. The second way is through innovation, the creation of a new product or service or innovation in an existing product or service reducing factor income costs. A new product or service again increases velocity and may, if its input costs are lower than the goods that would otherwise have been bought may additionally increase profit for the innovating firm. An improved technique may reduce input costs whilst maintaining price and increasing profit. Finally by extending the market. The latter two aspects are likely to attract increasing returns providing this is with the organisational capacity of the firm and the capacity of/costs serving the local market at which point decreasing returns will set in. Although the first two of these possibilities will reduce profit at other firms all three will increase the average rate of profit and total factor income available for investment. This is not to say there will not be disproportionality between different sectors with different labour productivities during growth creating sectoral structural employment.
By dividing the sources of profit, which may of course be financed by different means, in this manner we can distinguish, as for example Michael Hudson’s work does, between productive growth and rentier income extraction. I should stress that speculation on intangible assets, like speculation on any asset, is not the same as investment, the profits are not yet realised and fundamentals are uncertain and may be far less than anticipated, as the dot-com bubble demonstrated.
This is a factor return to equity of the firm, not entrepreneurship per-se. There are many entrepreneurial actions that never attract financing. It is the entrepreneurial action however that gives the equity value, though not necessarily the entrepreneur that receives the benefits as the discount the venture capitalist applies to uncertainty may be very high. Entrepreneurial action is the action of combining other factors of production. Of course for many years theorists have speculated whether entrepreneurship earns a factor return, and often the response is that entrepreneurship is combinative of factors rather than being a factor in itself. Attempts to identify entrepreneurship as a factor like all others earning a ‘marginal product’ has run into difficulties.
[E]ntrepreneurs obtain remuneration for their activity in a very different manner than do laborers or lenders of capital. The latter provide factors of production which they sell to the entrepreneur at prices which they naturally try to make as high as possible. The entrepreneur proceeds quite otherwise; instead of selling something to the enterprise he identifies himself with the enterprise.. Some people doubtless will say that he provides the function of enterprise and receives as remuneration a sum which varies according to the results. But this is a tortured way of presenting the thing, inspired by an unhealthy desire to establish arbitrarily a symmetry with the other factors. In reality, the entrepreneur and the firm are one and the same. (Jean Marchal 1951)
The marginal or factor-of-production approach holds that entrepreneurs enter and exit the market for entrepreneurship based on (exogenous) profit rates. For Mises, Knight, and … Marchal, it is entrepreneurship that creates profit. (Klein 2010)
My previous approach on this matter was flawed in failing to account for how firms can capture franchise value which can be created by entrepreneurship but is not a return to entrepreneurship, rather it is an income returning to equity holders which correctly recognise the value creating potential of entrepreneurship. The new approach however avoids some of the key problems of the ‘entrepreneurship as a factor return’ approach with its focus on the firm and the creation of profits via intangible assets. Like interest it is a cross cutting factor were as interest acts as a ‘tax on profits’ to use Schumpeter’s phrase franchise value acts as a reservoir of profits to the owner of the firm, the intimate knowledge of the firm of its own products, market and technology gives it an edge over new entrants producing the same products and enable it to earn a ‘quasi rent’ from this knowledge.
Those of Austrian persuasion would argue that profit is not a return, i.e. a rent, it is the result of arbitrage activity due to the alertness of the entrepreneur, rather than being a ‘resource’, and that as a result entrepreneurship is not a class of productive factor. But our new approach is immune from the Austrian critique as it focuses on the actions on investors creating equity in the market positioning of entreprenuers, that if proven correct yield a profit. A correct hunch is a resource which can be capitalised and therefore earn a rent to the investor.
6. Similarities and Differences with Leibowitz’s Franchise Value Approach
This approach is related to the Franchise Value approach to firm valuation developed by former head of research at Solomon’s Martin Leibowitz. His approach is how firms should be valued in terms of their growth prospects. My starting point is how equity gains a return separate from factors which could be rented.
Leibowitz uses the ‘full payout’ approach to share valuation where all earnings from a firm are immediately paid out in dividends, and extends this approach to look at future earnings from organic growth. Given this assumption a firm’s organic growth would have to be financed from the markets not retained earnings and so would have to be at least equal to the risk adjusted cost of capital. Leibowitz then concludes that additional growth must earn a ‘franchise spread’ above this cost of capital.
To achieve a positive franchise spread a project would by definition have to draw on the resources that were unique or at least special to the firm – patents, licences, distribution networks, brand recognition, particularly efficient manufacturing capabilities, and so. In other words, to be additive to the firm’s economic value, a project must have some special franchise like quality…A firm’s growth derives from new projects having returns that provide a positive franchise spread above the [risk adjusted commodity cost of capital] …Thus the key to productive growth is the magnitude and returns associated with these franchise opportunities. It is these project opportunities which that are the source of the value derived from growth. (Leibowitz 2004)
This insight seems to have achieved little recognition from economists however, perhaps because it was expressed through a financing lens rather than economics. Where I differ from Leibowitz is that a good part of existing value must derive from franchise value, though the extent to which this can be projected as future profits and capitalised is full of controversy. Also much future investment will be replacement of non-durable fixed capital, and will be financed through retained earnings rather than the market, especially where the firm projects a higher than average rate of profits and the information asymmetry created by franchise value gives the firm an insight into future opportunities that the market would mark up as risk adding to the cost of capital. Also much investment is for securing rentier income from takeovers, asset stripping, arbitrage etc. again where the insights of the firm and synergies with the existing firms franchise value created asymmetries with competitors and a larger franchise spread with the new combined entity. For the case through where existing factors are rented and new investment in new processes must come from the market Leibowitz is spot on, new growth can only come and will only come from franchise value as the only source of growth related profits.
Consider the recent case of Starbuck’s tax evasion. A profitable company makes itself look unprofitable by ‘renting’ its franchise license from a company in another tax jurisdiction and so treating profits as a cost, wiping them out for tax purposes in the first country. If that does not tell us something about the root cause of profits nothing does.
7. The Theory of the Firm and the Economics of Growth
Our approach may offers insights into the unification of the theory of the firm and value theory.
Much of the advances in theory of the firm revolves around the puzzle of why do firms exist at all? The approach set out here would support the resources based view of (Penrose 1959) much more than the transactions centred view of (Coase 1937). In the resource based view firms exist (in non-tax justification terms) to capture and create intangible profit raising assets to greater extent that is possible with a sole practitioner owner/manager entrepreneur. Minimising transaction costs, like all costs, is simply the consequence of this cause.
In addition we now finally have an explanation for total factor productivity and the Solow residual. Also in separating out speculative asset fuelled ‘growth’ to capture rentier incomes from innovation fuelled growth through production we have a tool for analysing balance sheets and flow of funds accounts to determine economic fundamentals.
8. How Keynes, Schumpeter, Mises and Marx nearly got there
Although modern neo-classical economics doesn’t recognise the existence of a ‘profits puzzle’ it greatly exercised the minds of our greatest economics thinkers.
(Marx 1885) of course in his M-C-M’ conception of the monetary circuit recognised the puzzle of profits, where does the addition money for profit come from? For him it was a monetary puzzle not a value puzzle as for him surplus value explained the source of profit. Whilst at this stage making no comment on exploitation theories of profit I note that if profit=sv=franchise value is taken as an identity then there must be a change between input and output prices as prices no longer=value. This adds some weight to that unfortunately most dogmatic of economic schools the Temporal Single System Approach, but with a reversed causation. It is the franchise value which creates a ‘hidden’ rise in value which if acted upon or if capable of being acted upon would lead to input prices rising to output prices,
For (Schumpeter 1934) approaching the issue back to any ‘originary’ factor, labour or land still posed the puzzle as these would be bid to zero in a competitive market. His solution, credit used to fund innovation by entrepreneurs, came very close to the solution presented here.
Mises fully recognised goodwill as a key cause of profits in several of his works
From the point of view of the seller good will is, as it were, a necessary factor of production. It is appraised accordingly. It does not matter that as a rule the money equivalent of the good will does not appear in book entries and balance sheets. If a business is sold, a price is paid for the good will provided it is possible to transfer it to the acquirer. ((von Mises 1949) Human Action Chapter XVI part 7)
but this insight did not permeate through to a full theory of factor returns and market process. Again the Austrian fear of accounting identities let them down.
The most tantalising near miss was Keynes who had a draft chapter on profits derived quasi-rents in his General Theory dropped in its final version (Bezemer 2010). Sadly this left Post-Keynsian economics without a full theory of price. Keynes was never able to get over the source of interest payments was in the discounted costs of factor inputs.
Our approach firmly centres profit as a disequilibrium arbitrage phenomenon where entrepreneur’s recognise the potential to transform factor inputs to higher value outputs in ways and means that cannot immediately and easily be copied by competitors. Whilst incorporating this ‘open ended’ view of the economy from Austrian thinking it does so in a way which is fully compatible with the sectoral balances approach adopted by Post-Keynsian economics (Vallageas 2000) (David Levy 2008) (Kalecki 1971) and enabling wider substitution between various equations. Indeed the great advantage of the sectoral identity approach, when combined with monetary balances, is the ability to create accurate models. A key task in developing the theory is extending the perspective from an individual firm to the whole economy in a coherent macroeconomic matter that has growth as an endogenous result. Indeed this new approach allows for a much more accurate treatment of the role of the firm, and different firm sectors, in such model.
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MARK COLVIN: One of the few economists who predicted the global financial crisis may find himself out of a job. The University of Western Sydney is planning to abolish its bachelor of economics program, and get rid of most of the staff who currently teach it. And the cuts to its School of Business goes even deeper.
Business reporter Michael Janda has more.
MICHAEL JANDA: They call it the dismal science but it’s the future of economics that looks dismal in Australia right now. Sydney University’s business school jettisoned its economics discipline into the Faculty of Arts two years ago.
And now the University of Western Sydney is looking to get rid of economics altogether. Arguably UWS’s most publicly prominent academic is economics professor, Steve Keen.
STEVE KEEN: I’ve had hedge funds funding me I’ve had the Institute for New Economic Thought funding me, I’ve got an international profile and I find it ridiculous that the university is simply deciding, oh well, let’s let all that go. And of course a major source of decent publicity for Western Sydney has been my activities in the last five years.
MICHAEL JANDA: In its formal change proposal, UWS says it will cut 29 full-time positions. The university has told staff the change is needed because business school enrolments have fallen markedly over the past two years, and look set to fall sharply again.
Associate Professor Brian Pinkstone teaches economics at UWS. He places much of the blame for falling student numbers on a change to Federal Government policy that encouraged greater competition for students between universities and resulted in lower entry requirements.
BRIAN PINKSTONE: Large universities like the University of Sydney and New South Wales have dramatically lowered their ATAR (Australian tertiary admission rank) cut-off entry points. And that this year particularly has had a big effect in dragging students away from making UWS as a first preference.
MICHAEL JANDA: Professor Pinkstone is concerned that the loss of economics from UWS may reduce career options for young people from Western Sydney.
BRIAN PINKSTONE: We take in students with relatively low ATARs and they end up with the best outcomes in the university in terms of employment prospects. And our best students are going to our honours program where every year, one, two or three might get into the Reserve Bank or Federal Treasury, State Treasury etcetera.
MICHAEL JANDA: One of those prospective honours students is Alison Lim. She learnt about the university’s proposal second-hand.
ALISON LIM: When I first heard about it I was quite in shock and I didn’t quite believe it. And I had to call up the honours coordinator for confirmation.
MICHAEL JANDA: UWS now looks likely to keep economics honours for next year. But beyond that, there won’t be much economics left.
Professor Pinkstone again.
BRIAN PINKSTONE: We’d end up with a situation where there was only one economic subject which would be introductory economic principles.
MICHAEL JANDA: And many in the business community are worried about the long-term impact of cutting back economics in business degrees.
Andrea Staines is a non-executive director of ASX 200-listed company QR National, and several other smaller firms. She says economics gives business leaders a broader view.
ANDREA STAINES: Business degrees are becoming just very focused on the here and now. And on sort of the first or second jobs that the student would take out of university. And what is missing is the broader skill set.
MICHAEL JANDA: UWS management met with staff this afternoon as part of formal consultation around the proposal.