From the article: I was reading an economics blog that mentioned the "Kalecki-Levy profits identity" and I was curious about what it was. A search lead to me to this explainer, which describes a...
From the article:
I was reading an economics blog that mentioned the "Kalecki-Levy profits identity" and I was curious about what it was. A search lead to me to this explainer, which describes a way of calculating the profits for a nation's business sector.
To start off, we need to define terms like investment and savings and wealth. From the article:
Investment here refers not to the purchase of stocks or bonds, but to activities that increase the total wealth in the economy, such as the construction of buildings and manufacture of business equipment. [...] Definitions of wealth vary; for example, the national income and product accounts
(the “GDP accounts”) recognize only a narrow class of wealth additions as investment:
structures, equipment, software, and additions to inventories of goods. [...]
This is a bit hand-wavy, but after reading further, I think it can be justified by looking at how accountants might measure an increase in wealth. This is based on transactions. Accountants will treat the purchase of a building as buying a long-lived asset, so there is no profit for the firm buying it. But if a construction firm built the building, the same transaction counts as revenue. Any increase in revenue gets added to profits somewhere (before subtracting expenses). Revenue can be classified as either consumer or investment spending, and how it's classified determines the increase in overall wealth.
In the following, we are talking about flows. That is, the amount of money spent in some time period.
[...] the new wealth the economy accumulates equals the new wealth the economy creates. In other words:
Saving = Investment
This is a tautology because it's based on just one way of measuring investment: the prices of the transactions when buying assets considered to be investments. But later, we will see other kinds of savings that don't necessarily result in investment.
Total saving equals the saving by the business sector plus the saving by all other sectors, hence
Business saving + Nonbusiness saving = Investment
This is drawing a line between businesses and nonbusinesses. For example, we exclude governments and maybe other organizations like financial firms from the business sector that we're interested in. So "nonbusiness saving" is any increase in long-lived assets by entities that we've decided don't count as businesses for our purposes.
This can be rearranged:
Business saving = Investment – Nonbusiness saving
Business saving is none other than profits after taxes and dividends. Therefore,
Profits after taxes and dividends = Investment – Nonbusiness saving
...
[...] we simply add dividends and profits taxes to both sides of the equation, and we get the following:
This is the profits equation. [...] [It] says nothing about causality.
To paraphrase, start with the total wealth increase in the period of interest for the entire country, subtract out any wealth increases that the business sector doesn't own, and then add back taxes and dividends, to get profits before taxes and dividends. (Why? See below.)
To explain this in more detail, they start with a toy cashflow model and gradually make it more complicated.
Money flows through the economy like water through an intricate network of pipes.
Dollars circulate continuously as they are received and spent by many different individuals
and organizations over the course of a year. Wages, profits, sales revenues, taxes, and
dividends are all flows of money, not static sums that sit in bank accounts or treasuries.
They start with an extremely simple model where all revenue is consumer revenue and revenue is equal to wages. There are no long-term assets and therefore no saving, so profits are zero.
Then they allow for personal savings and borrowing:
Suppose total wage income is $1000, but households save $60. Figure 3 illustrates what
happens to profits in this case: household saving diverts some money from cycling back
to the business sector as expenditures, reducing the stream of revenue to business by $60
while leaving business expenses unchanged. Profits, which were zero when households
spent all of their wages (figure 2) are now -$60. Business has a loss equal to the amount
households save. Personal saving is a negative source of profits.
To explain that in the more usual way: when consumers choose to lower their spending to increase savings, total revenue to businesses goes down and therefore businesses suffer losses. This is sort of like what happens in a recession. The model is still overly simple: it assumes that businesses don't react by cutting expenses and that consumers save their money in a way so that it's not invested in any business. Banks aren't modeled except as a storage tank for money.
The next step is to add investment to the model:
Net fixed investment is typically the largest and most important profit source in a capitalist
economy. It includes business investment in structures, equipment, and software. It also includes residential investment, which equals total outlays for the construction of all types of housing—from apartment buildings to single family homes—as well as outlays for additions and improvements. In keeping with NIPA conventions, we treat residential investment as another kind of business investment. This may seem puzzling at first, but there are good reasons [...] to consider home ownership a business.
They count asset purchases as immediate revenue for some other business (for example, construction). Since assets wear out over time, they deduct that gradually. They also account for changes in inventory:
Profits =
+ Gross fixed investment
– Capital consumption allowances
+ Inventory investment
– Personal saving
[...] it is now clear what determines the division of new wealth between profits and personal saving: the behavior of consumers. The identity method of deriving the profits equation did not indicate who or what decides what share of the economy’s new wealth goes to each sector. By contrast, the flows method shows that personal saving is a negative profit source and that it is largely at the discretion of consumers, who directly determine what part of income will flow on to the business sector as revenue. The more households save, the more they accumulate wealth at the expense of the business sector. Profits change in direct, immediate response to personal saving.
This is the same as it was in the simpler model: a drop in consumer spending reduces total revenue and causes a recession. But growth in investment spending does the opposite. If investors are exuberant enough, investment spending could counter a drop in consumer spending.
Also, while the article started out with Savings = Investment, no connection between personal savings and investment is modeled and they can vary independently. More personal savings might increase investment (which would counteract the decreases in revenue and profits), but it's optional. Banks don't have to lend and businesses don't have to spend.
The next step is to model international payments, which are very complicated, but they simplify it to:
Profits =
+ Net Investment
– Personal saving
– Foreign saving
When the a nation imports more than it exports, foreigners build up savings. As with personal savings, foreign savings could be invested to offset the drop, but that's modeled as an independent decision.
Next, they add government. Since the US government usually runs a deficit, they model government spending as negative savings:
Profits ($125) =
+ Net Investment ($150)
– Personal saving ($60)
– Foreign saving ($30)
– Government saving (–$65)
Then they add corporate income tax:
[...] Profits taxes are flows from the business sector to government, but although they are sometimes referred to as “profits tax expense”, they are unlike the business expenses we have mentioned thus far. They are distributions of profits calculated after profits have already been secured and tabulated. [...]
We noted above that all government revenue reduced profits. But now, with profits taxes, this observation must be amended: all government revenue except profits taxes reduces profits. [...]
Profits ($125) =
+ Net Investment ($150)
– Personal saving ($60)
– Foreign saving ($30)
– Government saving (–$5)
+ Profits taxes ($60)
This is by accounting convention. When we say "corporate profits," it usually means profits before corporate income tax, so it has to be added back in.
Similarly for dividends. (Stock buybacks aren't mentioned, but they could be included here.)
Corporations do not count dividends as a business expense [...] they do not flow backward through the profit meter but directly [...] to households. Yet households spend
this additional income. If personal saving remains constant, the full amount paid out in dividends will come back to business in the form of consumer expenditures—as business revenue.
Profits ($165) =
+ Net Investment ($150)
– Personal saving ($60)
– Foreign saving ($30)
– Government saving (–$5)
+ Profits taxes ($60)
+ Dividends ($40)
Then if you combine the different kinds of savings, this is the same as the identity given above.
From the article:
I was reading an economics blog that mentioned the "Kalecki-Levy profits identity" and I was curious about what it was. A search lead to me to this explainer, which describes a way of calculating the profits for a nation's business sector.
To start off, we need to define terms like investment and savings and wealth. From the article:
This is a bit hand-wavy, but after reading further, I think it can be justified by looking at how accountants might measure an increase in wealth. This is based on transactions. Accountants will treat the purchase of a building as buying a long-lived asset, so there is no profit for the firm buying it. But if a construction firm built the building, the same transaction counts as revenue. Any increase in revenue gets added to profits somewhere (before subtracting expenses). Revenue can be classified as either consumer or investment spending, and how it's classified determines the increase in overall wealth.
In the following, we are talking about flows. That is, the amount of money spent in some time period.
This is a tautology because it's based on just one way of measuring investment: the prices of the transactions when buying assets considered to be investments. But later, we will see other kinds of savings that don't necessarily result in investment.
This is drawing a line between businesses and nonbusinesses. For example, we exclude governments and maybe other organizations like financial firms from the business sector that we're interested in. So "nonbusiness saving" is any increase in long-lived assets by entities that we've decided don't count as businesses for our purposes.
...
To paraphrase, start with the total wealth increase in the period of interest for the entire country, subtract out any wealth increases that the business sector doesn't own, and then add back taxes and dividends, to get profits before taxes and dividends. (Why? See below.)
To explain this in more detail, they start with a toy cashflow model and gradually make it more complicated.
They start with an extremely simple model where all revenue is consumer revenue and revenue is equal to wages. There are no long-term assets and therefore no saving, so profits are zero.
Then they allow for personal savings and borrowing:
To explain that in the more usual way: when consumers choose to lower their spending to increase savings, total revenue to businesses goes down and therefore businesses suffer losses. This is sort of like what happens in a recession. The model is still overly simple: it assumes that businesses don't react by cutting expenses and that consumers save their money in a way so that it's not invested in any business. Banks aren't modeled except as a storage tank for money.
The next step is to add investment to the model:
They count asset purchases as immediate revenue for some other business (for example, construction). Since assets wear out over time, they deduct that gradually. They also account for changes in inventory:
This is the same as it was in the simpler model: a drop in consumer spending reduces total revenue and causes a recession. But growth in investment spending does the opposite. If investors are exuberant enough, investment spending could counter a drop in consumer spending.
Also, while the article started out with
Savings = Investment,no connection between personal savings and investment is modeled and they can vary independently. More personal savings might increase investment (which would counteract the decreases in revenue and profits), but it's optional. Banks don't have to lend and businesses don't have to spend.The next step is to model international payments, which are very complicated, but they simplify it to:
When the a nation imports more than it exports, foreigners build up savings. As with personal savings, foreign savings could be invested to offset the drop, but that's modeled as an independent decision.
Next, they add government. Since the US government usually runs a deficit, they model government spending as negative savings:
Then they add corporate income tax:
This is by accounting convention. When we say "corporate profits," it usually means profits before corporate income tax, so it has to be added back in.
Similarly for dividends. (Stock buybacks aren't mentioned, but they could be included here.)
Then if you combine the different kinds of savings, this is the same as the identity given above.