Profits

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Profits

PRODUCTION FINANCE AND THE ENDOGENEITY OF MONEY

Any discussion of profits must carefully distinguish between profits at the microeconomic level of the firm and profits at the macroeconomic or aggregate level, that is, in the economy as a whole. In mainstream economics, the existence of profits at the microeconomic level is not a complicated issue: An individual firm can make profits or losses in the short run based on its sales and the price at which its good or service is sold. In other words, as long as total revenue is greater than total costs, gross profits are realized. In perfect competition, given the nonexistence of barriers to entry, economic profits are necessarily nil in the long run—a condition of equilibrium analysis, where marginal cost must be equal to marginal revenue.

At the macroeconomic level, orthodox or mainstream economists associate the existence of profits to market imperfections: As stated above, profits do not exist in perfect competition. Yet, by allowing for some imperfections, profits will exist in less than perfectly competitive markets, such as in oligopolistic markets and under monopolistic competition, to name a few. At both levels, profits are always maximized by firms.

A second explanation of profits in neoclassical theory sees them not so much as a surplus value where a firm’s revenues are greater than its costs. Instead, we can also see profits as a reward: If an individual has savings, he can choose to consume today or postpone his consumption to a later date and lend his savings to someone who is willing to borrow them. In this sense, the lender is reimbursed his initial loan plus interest, which is his reward for sacrificing consumption today for consumption tomorrow.

For heterodox economists, however, the existence of monetary profits at the macroeconomic (aggregate) level has always been a conundrum. In fact, as we will see, they do not exist—that is, at the macroeconomic level, profits are necessarily nil in theory. This conclusion poses a number of challenges that are tied to the way in which production is financed and the way money is created by bank credit. Yet, profits must exist so that at the macroeconomic level, firms as a whole are able to cover not only their costs of production but also the interest on their bank debt. So where does the extra money come from? To borrow a popular expression from Karl Marx (1818-1883), how does M become M’ ?

PRODUCTION FINANCE AND THE ENDOGENEITY OF MONEY

For heterodox economists, firms do not finance production or purchase capital goods with prior savings. Indeed, unlike in neoclassical or mainstream theory, savings only play a passive role in the production process. This is but the first of the reversed causalities within heterodox economics. Rather, since the economy is seen as a logical sequence of irreversible events that operate in historical time within a monetary economy, savings arise from income that logically follows a prior investment. Two questions arise. First, if investment is not financed by savings, how is it financed? Second, will this have any implications for the generation of profits?

Overall, heterodox economists see the economy as a dynamic interactive process between various social groups, such as wage earners, firms, and banks. Such a class-based approach is at the heart of the explanation of macroeconomic profits.

In a monetary economy of production, as advocated by John Maynard Keynes (1883–1946), this circuit of irreversible events begins with the determination of production plans by firms (planned production)—that is, wages are set and production levels are determined, as are other costs of production, such as the rate of interest, exogenously determined by the central bank according to its policy objectives. At this stage, therefore, firms are able to properly determine their financing needs for the production process to begin. In the aggregate, we can argue that firms need to borrow M.

As Keynes pointed out, “banks are special,” in the sense that they are entrusted with the role of financing the production process: They “hold the key.” Banks are therefore an important part of not only the production process but also the realization of profits, as we will see below.

Once firms approach a bank for the financing of their production plans, banks will then evaluate the creditworthiness of the potential borrowers. Provided firms have the sufficient collateral to secure a loan, or provided they otherwise meet the strict lending criteria of the banks—such as the firm’s ability to generate profits, the firm’s net worth, the firm’s ability to withstand transitory shocks, and certain key financial ratios, such as cash flows and debt/equity—they will receive the funds to cover their production costs, which may be called the initial finance phase. Of course, some firms will not be able to secure credit, thereby jeopardizing production and output (Graziani 2003).

Once credit has been secured and a loan is made, usually as a line of credit, firms will draw on their line of credit to pay wages and purchase other inputs of production. As they pay wages, bank accounts of wage earners will increase; money is created. In this sense, the creation of money is parallel to the creation of incomes.

Once incomes are created, wage earners will carry out their consumption and saving plans according to their needs. As they consume, money flows back to firms as revenue as they sell their goods and services to consumers. In this sense, firms are able to capture a portion of their initial outlays from the direct consumption by wage earners in the overall economy. Firms will use these funds to extinguish their existing debt toward the bank, which in the process will also destroy money.

Once their consumption plans are carried out, wage earners will assign the remaining component of their wages to savings. We can identify two types of savings: financial savings, which are used to purchase obligations on financial markets, and hoarded savings, which then remain in the wage earners’ bank account, which consists of the demand for money balances.

Although both types of savings may appear similar, they are in fact very different and play very different roles. In the first instance, when households purchase financial obligations, these funds flow back to firms. Firms will then use these funds to reimburse their debt toward the banking system. In this sense, as Keynes once argued, there is no difference between consumption and financial saving, as they both play the same role. Both are, in fact, part of final financing. This is the reflux phase of the circuit of production. It is the phase of the destruction of money.

From the above discussion of the economy as a monetary circuit, two fundamental conclusions about the heterodox approach can be drawn. First, the money supply is endogenous and responds to the needs of production (Lavoie 1992; Moore 1988; Rochon 1999). Credit creates money, which is another reverse causality inherent in the heterodox approach. Money endogeneity suggests therefore that there is no excess money. The money supply always adapts to the requirements of the economy; such is the characteristic of a monetary economy of production.

Unlike neoclassical theory, where the money supply is an exogenous stock imposed by the central bank, heterodox economists consider the flow nature of credit and money as a fundamental characteristic of production economies. In this sense, the banking system is at the heart of the production process and of the endogeneity of money. The existence of money therefore is the result of debt between firms and banks. Heterodox economists therefore argue that the money supply is credit-led and demand-determined.

The second conclusion, however, is even more important. Indeed, if firms borrow M, how can they make any profits if, at best, they succeed in capturing only M, assuming no savings? Even more importantly, how can firms in the aggregate generate revenues to even pay the interest on their bank loan?

Granted, the above example is a simplified model, but even if we were to complicate the model by adding a government, the open economy, or additional realistic characteristics of a production economy, it would not change the fundamental conclusion that, at best, firms can only succeed in capturing what they injected into circulation at the beginning of the circuit. The question, therefore, is simple: If profits exist at the macroeconomic level, how can we explain the transformation of M into M’ ?

Heterodox economists have proposed a number of possible solutions to this conundrum. For instance, some have suggested that profits can be accounted for, provided we assume several circuits that overlap with each other. In other words, in the real world, production periods are staggered in the sense that firms or sectors do not borrow and reimburse their debt all at the same time. As such, several sources of monetary outlays would exist simultaneously, thereby providing firms with more than M at any one time.

Another possible solution consists in considering the existence of the state or an open economy. Under each of these conditions, there is an additional injection of outlays coming from the state and from other countries. In this sense, when the government undertakes fiscal expenditures, they increase aggregate demand and translate into additional revenues for firms. Yet, the problem with this solution is that while expenditures are revenues for firms, taxes are a drain on the circuit. As such, for this solution to be a viable and general solution, it requires that governments consistently incur fiscal deficits.

In an open economy, of course, countries are increasing their exports, which increase the proceeds of domestic firms, with which they can extinguish their debt toward the banking system and show some profits. This additional influx of revenue would account for the transformation of M into M’. Yet, as in the above example, this solution remains a limiting case, and not a general solution: While exports represent an influx of additional revenues, imports are the opposite. In this sense, this solution only applies in situations of net exports (trade surplus).

There is no doubt that all the above suggestions contribute in some way to the existence of macroeconomic profits. Yet, they all consist of ultracircuit explanations, in the sense that they all require that we amend the basic circuit by allowing some external explanation, such as the state, the rest of the world, or additional, overlapping circuits. What is required is a general theory of macroeconomic profits that applies in all circumstances.

For Marxists, since the value of goods reflect the labor hours used in their production (the labor theory of value), profits can be explained because capitalists are able to extract from labor a greater value out of their work or labor power. In other words, capitalists, as owners of the means of capital, are able to exploit workers: Capitalists are thus able to extract “surplus value” from the workers and enjoy profits.

A GENERAL THEORY OF PROFITS

How can we therefore account for profits within a single period of production without relying on external solutions? Recall that until now, this entry has said nothing about the financing of investment. Yet, just like production, investment must be financed. Assume therefore that like wages, investment is financed with the use of bank credit. Yet, unlike wages that are financed with short-term credit that needs to be reimbursed at the end of the production circuit, investments are long-term credit: Firms do not reimburse the whole value of investment within the same period, but rather typically reimburse investment over several periods. In that way, while firms in the aggregate borrow to cover wages (and other costs of production) and the purchase of investment goods, they only reimburse a fraction of that total value, which accounts for the existence of profits at the macroeconomic level.

SEE ALSO Capitalism; Capitalist Mode of Production; Economics; Economics, Marxian; Economics, Neoclassical; Economics, Neo-Ricardian; Economics, Post Keynesian; Entrepreneurship; Long Period Analysis; Marginalism; Markup Pricing; Profitability; Rate of Profit; Surplus; Surplus Value