Why a Shrinking Deficit Means Lower Earnings

Proponents of tax increases or government spending cutbacks will have to reckon with something they never anticipated: depressed corporate earnings that will reduce equity prices. As our government deficit shrinks – whether through sequestration or by any other means – so will corporate profits, the primary driver of equity prices.

A mathematical identity governs the relationship between government budget deficits and corporate profits, known as the profit equation. Credit that contribution to Michal Kalecki, a Polish economist who was a contemporary of John Maynard Keynes. Kalecki showed that deficits and profits move in tandem; a larger deficit is accompanied by greater profits, and vice versa.

The profit equation is non-ideological. It does not say that the government should run deficits at certain points in the business cycle. But it says a lot about the unavoidable impact of changes in the deficit.

Because the economic theory behind this phenomenon is not easily understood, the occasional warnings about the profit equation have gone unnoticed by the financial media and investors at large. It involves aggregate economic variables. For example, consumption must equal earnings, because one person’s purchases are another’s income.

A few prominent observers – John Hussman and James Montier – have warned about the ramifications of Kalecki’s profit equation. I’ll look at what they and others have said, as well as the implications for investors.

Deriving the profit equation

John Hussman provided me with a straightforward derivation of the profit equation. He began with a simple identity, but one which may not be intuitively obvious:

Investment = Savings

The left side is the gross investment across the economy; it is the money put to work by corporations and individuals in financial assets and capital expenditures. This must equal the right side of the equation, which is the funds saved by those entities. Money saved by corporations or individuals must be invested – in a bank account, bond, stock or other financial asset. If an entity borrows to invest more, it creates a financial liability (the amount it borrows) that offsets the additional investment, maintaining the above identity.

Expanding the right side of the equations into its components:

Investment = Household Savings + Government Savings + Corporate Savings + Foreign Savings

Foreign savings is the inverse of the current-account deficit. The U.S. has run a current-account deficit — meaning it imports more than it exports — since World War II, when the dollar became the reserve currency. If it were to run a current-account surplus, that term would appear on the left side of the equation.

Rearranging the terms in the previous equation:

Corporate Savings = Investment – Foreign Savings - Household Savings – Government Savings

Corporate savings can be split into its components:

Profits – Dividends = (Investment – Foreign Savings) – Household Savings – Government Savings

The reason (investment – foreign savings) is in parentheses is because particularly in U.S. data, they have a very strong inverse relationship, as “improvements” (increases) in the current-account deficit are generally associated with a deterioration in gross-domestic investment – see the chart in this commentary from Hussman. The term in parentheses adds very little variability over the course of the business cycle. Likewise, dividends are fairly smooth and add very little variability over the course of the business cycle.