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:
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.
As a result, the above equation reduces – from the standpoint of overall variability – to a statement that the variability in profits is primarily driven by variability in household savings + government savings. Hussman’s charts in the above-referenced commentary provide empirical evidence of the strength of that relationship.
According to Hussman, “the Kalecki equation reduces, for all practical purposes, to a statement that corporate profits move opposite to the sum of household and government saving.” See the charts in this commentary for historical evidence of this relationship. The chart below, in particular, shows that “corporate profit margins have always moved inversely to the sum of government and household savings,” according to Hussman.
Household savings are at record-low levels. As they revert to the mean, pressure will increase on corporate profits. As the government reduces its deficit through tax increases or measures such as sequestration, government savings increase, amplifying the pressure on corporate profits.
James Montier of GMO provides an alternative derivation of the Kalecki profit equation. In that commentary, written in 2012, he noted, “the stand-out engine of corporate profits of late has been the fiscal deficit.” In 2011, corporate profits made up 10.2% of GDP; of that, 7.6% was due to growth in the budget deficit, according to Montier.
Here’s one more view of the relationship between the capital account (the current account deficit), private sector (household and corporate) balances and the government deficit, courtesy of Stephanie Kelton, a professor at the University of Missouri-Kansas City.
Since the onset of the financial crisis, private-sector balances have been in surplus, as households have delivered and corporate profits have surged. In tandem – and by definition this must have happened – the government deficit expanded.
Implications for investors
Over the last two years, the government deficit has been shirking – sharply so – which you can see in this commentary from Charles Schwab. The government actually ran a surplus in June.
The deficit reduction has come from a combination of higher revenues (more taxes paid as unemployment has come down) and lower expenditures (through measures such as the sequester).
One cannot be certain when the deficit reduction will trigger a decline in corporate profits, but its impact is inevitable. The timing will depend on other factors – changes in household saving rates and in the current-account deficit. The effect on stock prices will be masked by changes in market price-to-earnings ratios.
While the reduction in the deficit has been widely cited, few have noted its adverse impact on corporate profits. Other than Hussman, GMO and this commentary from Fidelity, it’s unlikely you’ll find any other analysts citing Kalecki’s profit equation. Indeed, the commentary above from Schwab doesn’t reference it; instead, Liz Ann Sonders, the author of that commentary, touts the “resilience of the private sector during the public sector’s retrenchment.”
Sonders concludes, “It shows that the government can and should continue to deleverage without tanking the economy, thanks to the relatively healthy private sector. This is encouraging; especially since the government sector’s deleveraging is already paying deficit dividends.”
That statement is neither supported by economic theory nor borne out by empirical evidence.
The relationship between government deficits and corporate profits is inescapable. Kalecki’s profit equation is neither intuitively obvious nor easy to explain, which underlies its obscurity.
It’s also intellectually unappealing. Investors would like to believe, along with Sonders, that shrinking the deficit would be good for corporations, profits and stock prices.
