Tuesday, November 24, 2015

The Paradoxical Kalecki (part ii)

(From part i)

For convenience, let's repeat the argument presented last, adding some emphasis:
"Answering the question 'Where do profits come from?' requires a macroeconomic perspective. Profits are produced by specific macroeconomic flows of funds. Unfortunately, the macro perspective necessary to investigate these flows can be elusive because of a logical trap: the tendency to assume wrongly that circumstances that apply to the familiar case of the single firm also apply to the entire business sector.
"To illustrate the problem of applying a microeconomic perspective to a macro situation, consider the following. As every entrepreneur knows, employee costs are a major influence on a firm's profits. Cutting payroll expenses means a more robust bottom line. Accordingly, it is commonly believed that when firms throughout the economy hold down wages, they improve aggregate profits. However, for the whole business sector, cutting employee compensation reduces revenue as well as expenses. Less worker pay means less personal income and, therefore, less personal spending on the goods and services sold by businesses. Therefore, cutting payrolls will not directly increase corporate profits".

Although less attractive than the figures in the Levy publication, let's study that argument from a strictly macroeconomic perspective, using -- however -- traditional diagrams of circular flow of the economy, much in the way Kalecki's equation is derived. Hopefully, this shall protect us from the ubiquitous fallacy of composition.

That's the baseline scenario, for a closed capitalist economy, without government:

It's equivalent to Figure 2 of the Levy publication, except that this diagram, unlike Figure 2, includes flows of goods and services and factors of production (in red) and also differentiates factor incomes. (For purposes of comparison, the link to the Levy publication.)

Firms (in fact, capitalists who own them) decide how to spend Y dollars: they pay workers W in wages for labour (L), and they pay themselves P in profits, for the use of their capital (K); together W + P = Y (GNP by income source). The egg hatched.

Households (workers and capitalists) have Y dollars to spend; they pay firms Cw (for consumption out of wages), Cp (for consumption out of profits), and I for investment goods. [*] Firms again have Y dollars for the next cycle. Together, Cw + Cp + I = Y (GNP by expenditure). The chicken laid a new egg.

Let's examine something.

If workers spend what they get, as Kalecki writes, then Cw = W.

Again setting GNP (by income) = GNP (by expenditure) and subtracting W from both sides, we find Kalecki's simplest equation:

(2)          P = Cp + I.

Capitalists get what they spend. That's the same equation (1) from last time.


Now, a scenario where capitalists cut their payroll (compare it to the previous diagram):

We proceed exactly as we did above. Firms start with Y dollars, for wages (W') and profits (P'), only now capitalists re-distribute them (hence, the apostrophes), without affecting employment or capital: firms cut hourly-wages, such as to save in aggregate a positive amount D and re-distribute that amount as dividends to their shareholders. In short: W' = W - D and P' = P + D.

GNP (by income) was re-distributed, but it does not change in aggregate:

             GNP' = W' + P' = (W - D) + (P + D) = W + P = GNP.

As employment and capital remain constant, there is no reason to believe physical output changed.

Households in aggregate are in possession of Y dollars.

Workers still spend what they get:

             Cw' = W' = W - D = Cw - D < Cw.

But they spend less than before: i.e. their contribution to aggregate demand falls, exactly as the Levy publication would have it.

But capitalists gained what income the workers lost: P' = P + D > P. Furthermore, there is physical capital, labour and output enough to cover their increased demand, should they choose to increase it: this available capacity was made possible by the workers' smaller aggregate demand. All of this seems fairly evident, but you wouldn't know it from the quote above.

But, would capitalists spend this extra income? Well, why not? For one, I see no reason capitalists' demand should not cover the fall in workers' demand, such as to keep aggregate demand constant. Maybe one could add an additional assumption to force that result, but the Levy team did not -- explicitly -- add anything, let alone defend it. (More on this in the concluding post of this series.)

For another, according to the interpretation given to equation (1) workers' demand is irrelevant to capitalists' profit, which depends only on their own spending decisions.

Therefore, I'll conclude that in aggregate, consumption, too, was re-distributed. Some consume more, some  less. But there was no recession: aggregate demand, output and employment did not change.

Finally, we find (consistent with Kalecki's dictum: capitalists get what they spend) that:

(3)          P' = Cp + I + D.

Compare equations (2) and (3). This is precisely the opposite of the Levy claim above ("cutting payrolls will not directly increase corporate profits"): payroll cuts did increase corporate profits. Every single dollar lost to workers (- D) went to capitalists' pockets (+ D) and the world did not come to an end, GNP and employment were unaffected. Only income and consumption were re-distributed.

And this result was arrived at using macroeconomic flows of funds. Fallacies of composition, anyone?

So, what gives?

In the next and final post in this series we'll discuss the reasons for this paradoxical result, with numerical examples. (Hint: re-read the quote opening, paying particular attention to the two sentences emphasised.)

[*] Cw + Cp = C, in the popular macroeconomic convention for private consumption.

(To be continued)


  1. Greetings Magpie!

    I have enjoyed the first two parts of your blog’s trilogy on Kalecki, and appreciate your acknowledgement of our firm’s work on profits. I did not find any fallacies of composition in your work but I do see a problem with your analysis.

    You partly assume your conclusion to start: revenues are fixed at Y. If you cut wages and did not increase dividends, and kept your other assumptions the same, your revenue would fall short of Y and profits would not rise. Indeed, it is the increase in dividends—a profit source—that creates additional profits, not the wage cut. This can be seen if you rerun your example with a raise in dividends without any wage cuts. Thus, all you prove is that increasing dividends increases profits.

    Robert King
    The Jerome Levy Forecasting Center

  2. Thanks, Robert King, for your kind comments.

    I've been thinking pretty much along the lines of your comment (i.e. implicit assumptions, and whatever happened to D) but I still reach a different conclusion.

    Hopefully, the final post will clarify these points.

    Best wishes.

  3. Good stuff, Maynard. I'm not sure you're correct, but even if you're wrong, you're wrong in the right way.

    I'll have to think about all this carefully.

  4. Sorry, old joke. It's from an old commercial for breakfast cereal: "It's good stuff, Maynard." I have a lot of weird stuff lying around in my brain.