July 16, 2016

Stock prices, profit, and other self-fulfilling idiocies

Comment on David Glasner on ‘Stock Prices, the Economy and Self-Fulfilling Prophecies’

Blog-Reference and Blog-Reference and Blog-Reference adapted to context

You quote Paul Krugman saying:#1 “The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. “

And, elaborating on this point: “This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly.”

Obviously, economists do not really understand what profit is and where it ultimately comes from. As the Palgrave Dictionary summarizes: “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10). Or, as Mirowski put it “... one of the most convoluted and muddled areas in economic theory: the theory of profit.” (1986, p. 234)

So, in effect, Krugman, Glasner, and the blogging rest try to explain stock market valuation as a reflection of profit expectations without having any idea of what profit is. What the general public cannot see is that this abysmal scientific blunder is all-pervasive and that the representative economist does not understand the pivotal phenomenon of his subject matter.

For this reason alone, the whole discussion about stock market valuation and efficient markets is vacuous. The root cause of why the profit theory is false lies in the Fallacy of Composition, that is, economists take propositions that are true for a single firm and generalize them for the economy as a whole (2013).

The correct profit theory follows from the analysis of the pure production-consumption economy which is the most elementary case (2011). From this analysis follows:

― The business sector’s revenues can only be greater than costs if, in the simplest of all possible cases, consumption expenditures are greater than wage income.

― Overall profit does neither depend upon the agents’ personal qualities, motives, their ideas about what profit is, nor on profit-maximizing behavior. Overall monetary profit is NOT explainable by subjective factors but is OBJECTIVELY given by the Profit Law which can be tested in principle by summing up what is in the cash boxes or on the bank accounts.

― In order for profit to come into existence for the first time in the pure production-consumption economy the household sector must run a deficit for at least one period. This presupposes the existence of a credit-creating entity.

― Profit is, in the simplest case, determined by the increase and decrease of household sector’s debt. There is a close relation between profit/loss and the expansion/contraction of credit for the economy as a whole.

― Wage income is the factor remuneration of labor input. Profit is NOT a factor income. Since capital is nonexistent in the pure production-consumption economy profit is not functionally attributable to capital.

― There is NO relation at all between profit, capital, marginal or average productivity.

― Profit has no real counterpart in the form of a piece of the output cake. Profit has a monetary counterpart. In a real exchange economy, profit does not exist.

― The existence and magnitude of overall profit do not depend on the ownership of the firms that comprise the business sector. The Profit Law holds for capitalist and communist economies alike.

― The value of output is, in the general case, different from the sum of factor incomes. This is the defining property of the monetary economy.

― Profit is a factor-independent residual and qualitatively different from wage income. Therefore, it is an elementary mistake to maintain that total income is the sum of wages and profits.

― There is NO antagonism between total wages and total profits, and the distribution of consumption goods output has nothing at all to do with profit.

― Innovation and efficiency are IRRELEVANT to the profit of the business sector as a WHOLE. It is a logical mistake to trivially generalize what can be observed in an individual firm. The same holds for monopoly power. These factors affect the DISTRIBUTION of profit among firms but NOT the overall volume.

All this follows from the elementary case of the pure production-consumption economy. The Profit Law for the investment economy reads Qm≡Yd+I−Sm (2014, p. 8, eq. (18)). Legend: Qm monetary profit, Yd distributed profit, Sm monetary saving, I investment expenditure. The Profit Law gets a bit more complex when foreign trade and government are included.

In the last decades, overall (= world) profit has been driven by the growth in Asia (= high I), by dissaving, i.e. the growth of private debt mainly in the USA, by the growth of public debt worldwide, and by substantial profit distribution mainly in the USA. Overall profit has been distributed between the countries via export surpluses/deficits.

Roughly speaking, as accumulation (= I) slows down in China/Asia and the developing regions overall world profit goes down, then overall profit distribution goes down, then again profit goes down, then investment goes down again, and so on. Rising unemployment and falling wages ACCELERATE the downward spiral (2015). The market economy is NOT self-adjusting.

Does this matter for stock valuation? Not much, as long as the central banks stand ready to stabilize the stock markets. This is what the market participants have observed in the past and expect for the future, independent of the performance of the real economy. This is where the disconnect between overall profit and overall stock market valuation comes from.

Egmont Kakarot-Handtke

Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, 1–11. Palgrave Macmillan, 2nd edition. URL
Kakarot-Handtke, E. (2011). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Mirowski, P. (1986). Mathematical Formalism and Economic Explanation. In P. Mirowski (Ed.), The Reconstruction of Economic Theory, 179–240. Boston, Dordrecht, Lancaster: Kluwer-Nijhoff.

#1 Bull Market Blues