True Meaning of Profit
by Dan Lieberman, Alternative Insight
Capitalism needs profit in order to grow and generate its periods of prosperity.
The opposite is not true; profit is not tied to capitalism and other economic systems can incorporate it for growth and material enrichment. The true meaning of profit shows that capitalism is an antiquated economic endeavor in its use of profit. A more efficient and effective use of profit, which has significant benefits, can be employed by a severely modified capitalism.
Because profit is the lifeblood of the capitalist system, understanding the modern concept of profit -- how profit is made, its functions, problems, benefits, and failures -- provides an improved understanding of the contemporary economic system. The discourse has original observations but cannot be devoid of ideas supplied by the classical economists -- Adam Smith, David Ricardo and Karl Marx. All the better; one major problem with contemporary economists is a retreat from classical economic theory and promotion of competing concepts of what is profit and how it moves capitalism. Enlarging upon basics relates an interesting story, meticulously deciphering the profit enigma and reaching surprising conclusions -- much maligned profit has significant purposes, a pursuit many wish they could abolish and most cannot do without.
The process toward profit begins with a simple identity
Cost (C) (total investment in production of goods) = Inherent Purchasing Power (IPP) (funds supplied by the entrepreneur in wages, interest, subsidiary profits, and rents to produce goods, which equals the final cost)
The total cost of production consists of wages, interest, rent, and supplier profits.
Theoretically the IPP should provide sufficient purchasing power to acquire the share of the production equal to the cost. Dangerous to capitalism's survival is that the theoretical is not practiced, not all of the IPP is available for purchase or is spent on the produced goods.
Before managing to obtain profits, entrepreneurs must first assure demand equals supply and be able to sell goods for which part of the purchasing power they placed in the system has been diverted to other ventures.
The price of goods Pr = C+ P, where P is profit.
In the production process, excepting for some subsidies, no funds are supplied to purchase the goods represented by profit, or as Karl Marx defined it, the surplus value, the value of goods that worker wages are insufficient to purchase and the capitalist appropriates. From where does this mysterious profit come? By realizing the components of the diversion of purchasing power and from where funds arrive to offset the diminished spending, the closeness of demand to supply and how profit is made can be determined. The list of components may not be complete but it gives an indication of the obstacles that impede the making of profit.
Diversions from inherent purchasing power (IPP) that prevent realization of costs.
Note: In this narrative, consumption assumes both consumer and capital spending.
- Repayment of debts reduces purchasing power.
- A portion of the IPP is used to purchase imported goods -- production external to the national system.
- A portion of the IPP is unconsumed and lays dormant in bank accounts.
- A percentage of IPP goes into retirement savings -- pension funds and Keogh Plans that purchase securities, which keep money circulating in the financial community and outside of the consumption economy.
- A host of financial investment vehicles --- speculative, derivatives, futures -- churn money and divert funds from purchasing goods.
In normal times, the first two components have an overwhelming role in diverting purchasing power.
For a valid reason, income taxation has not been included as a component. Government spending transfers taxes back into the economy by welfare, wages to federal employees and by purchasing products from industries that then pay salaries to workers. The same recirculation of taxes applies to the payroll tax (FICA), which transfers income to retirees who spend the funds; essentially having FICA serve as a limited redistribution of wealth. Undistributed tax is applied to the budget and spent by the government.
A substantial amount of purchasing power is diverted from consumption, enough to paralyze the economy, making it more an adventure than a well functioning economic system. How is the market rescued? Funds for purchasing the share of production represented by the IPP that is derailed from consumption and for acquiring surplus that enables profits come from several sources.
Increasing the Purchasing Power
- Private debt supplies a major increase in purchasing power.
- Exports bring purchasing power into the system, reclaiming dollars circulating throughout the word.
- Government deficit spending supplies the knockout punch to clear the shelves, growing when private debt shrinks.
- Distribution of profits by dividends, share buybacks, and bonuses to management and employees recirculate profits for purchase of goods.
- Some liquid funds from savings and investments re-enter the system.
The first four components operate strongly and actively to restore purchasing power.
Using published statistics for the above listed components, the Table below describes how debt is related to profit and to the current account deficit. Admittedly incomplete, the figures give a clue to how profit is subsidized.
Statistics for increases in domestic non-financial debt and corporate profits are found at Federal Reserve Releases.
The Bureau of Economic Analysis publishes data on current account balances.
Domestic corporate profits plus the current account deficit (diversion from purchasing power) shows a strong relation to the increase in domestic non-financial debt (including federal government deficits) plus corporate distributions (dividends). The relation is close for the years 1996 and 2013, less so for the years 2006 and 2008. Obtaining exact statistics is the problem. There is more to surplus value than corporation profits and more to adjustments to purchasing power than domestic debt and dividends. All of the components are dynamic and a slice of the economy at year end is a static story.
The Table provides interesting observations.
- A capitalist system, which is portrayed as a money making machine that turns capital into a continuous supply of manufactured goods and profits, lacks sufficient internal prowess and relies mostly on debt that can be converted into profit for capital expansion.
- Without government deficits, profit in the last years would have been greatly reduced and the economy would have stalled. Those who rail against government deficits as a threat to free enterprise have erred.
- The current account deficit removes substantial purchasing power from the economy, which must be replaced by debt. Those who claim that the current account surplus is meaningless because dollars are recirculated back into the economy fail to recognize that the dollars come back as a combination of government debt and selling of the nation's assets, both of which may have high limits but are not limitless.
- Corporations are paying out much of their profits in the form of dividends. This continuous recirculation of profits back into consumption provides a floor for future profits -- last year's dividends purchase next year's surplus.
Profit being made, shakily, but in huge quantities and for lengths of time, is the beginning of the profit story. The functions of profit is the significant story.
Functions of Profit
Investment into additional production and research and development are the principal functions of profit, yielding a path to growth and increased employment. In the years succeeding the 2008 recession, this did not occur; manufacturing employment and revenue grew slowly while profits, which were used to increase dividends, repurchase stock, amortize outsourcing and add to retained earnings, increased rapidly. This anomaly occurred because government deficits, rather than subsidizing growth, subsidized profits that were used to benefit relatively few rather than being reinvested in growth for all. The government was forced into continuous deficits in order to finance another deficit, which is the negative balance of trade -- dollars leaving the county that subtracted from internal purchasing power were repatriated by selling government securities to foreign investors.
Not well considered is that profit allows domestic credit and government deficit spending without provoking inflation. In a system where there is no surplus and workers' pay equals the price of all production, introduction of any additions to purchasing power will drive demand to be greater than supply and cause inflation.
Surplus, goods for which there is insufficient wages to consume, is the supply for additional demand. This demand comes from credit for amortizing expensive items (homes, cars), which would ordinarily require years of savings, and from those whose earnings are financed by deficit spending and who are not engaged in labor that produces more material goods for public consumption (welfare, defense industries, service industries). Because the latter type of wage earners do not add any consumer goods to market, the surplus accommodates the increased demand. Inflation will be mitigated until the added demand due to credit and deficit spending grows larger than the supply due to the surplus.
In many cases businesses shelter profits as retained earnings. Some holding is necessary to prepare for difficult times or unforeseen occurrences, but excessive retained earnings remove profits from recirculating as purchasing power. In large corporations, such as Microsoft and Apple, retained earnings have been purposely allowed to grow in order to be used for expansion by absorption --- buying competitors and other growing businesses. If government deficits have financed profits, then the American public has also directly financed takeovers.
Regardless of approaches to stabilize the capitalist system, the profit motive has built-in failures and must eventually collapse.
The ultimate failures of the profit system are apparent -- either securing debt to enhance purchasing power hits a wall, wants from all sectors are fulfilled, or workers become unavailable for increased production. Proper actions can slow the failures but not for ever.
Similar to a perpetual motion machine, capitalism grows by feeding back the profit it generates until its created friction confronts profit with unsupportable debt. Government debt has replaced diminishing private debt and fabricated demand for the surplus to be purchased. As long as federal debt does not increase the money supply so that demand becomes greater then supply, inflation will be checked and the value of the dollar will be maintained. It makes sense -- surplus goods add to the GDP and their value should be reflected by an increase in the money supply. The government has the markers to measure the tendency to inflation and the tools for controlling it -- higher interest rates and lower spending.
Government deficits have kept the capitalist system alive. These deficits can grow until the public becomes skeptical of the currency and creates a psychological herd effect that tramples the value of the dollar, or interest rates on government debt begin to increase rapidly. As of February 2015 neither situation is occurring and the Federal Reserve has not expressed any fears.
Arguments against government deficits insist they compete for and replace private investment. Neither argument has legs. Excessive government deficits are timed to be effective during economic downturns when demand for money remains low. Purchasers of federal securities are mainly pension funds and sovereign nations. By re-circulating into the economy pension fund investments and by repatriating dollars from a negative current account, the government creates much needed demand.
The Federal Reserve has supported government deficits by quantitative easing, which keeps interest rates low on government securities and has, by encouraging excess bank reserves, actually discouraged bank loans. A Cleveland Fed article Excess Reserves: Oceans Of Cash, February 14th, 2015, explains this audacious maneuver.
A quick comparison of the Fed's balance sheet and the amount of excess reserves shows an almost one-to-one correspondence between the two. This should not be surprising, since excess reserves are part of the banking sector's assets and the central bank's monetary liabilities. The Fed's actions to increase its monetary liabilities will raise bank reserves by a like amount, unless public demand for cash rises sharply. Because risk-adjusted returns on assets are so low, banks are holding these assets as cash instead of cycling the liquidity through the system in the form of loans. Consequently, despite massive infusions of liquidity into the system, banks' lending has increased only slowly, and after a long period of decline.
The Fed's policy of limiting lending to the public and encouraging lending to the government was undoubtedly based on the proposition that excessive leveraging played a decisive role in most economic setbacks and credit needed careful supervision. Realizing the need for debt to increase demand and assure profit, the Fed pushed the safer government debt, which carries less interest (that the Fed maintained historically low) and can be sidetracked by quantitative easing. A relatively weak recovery has been deliberately planned by strong reasoning, which could be fatal. Record profits, subsidized by government defects, have promoted the stock market rise and quantitative easing has steered money into buying assets and partially contributed to the stock market boom and possible "bubble."
As material wants of those who receive the rents, wages and profits become fulfilled, they spend for services whose workers then fulfill their needs and purchase goods. The service industry has grown greatly for that reason, which gives additional worth to its existence. The service sector may be a safety valve for the capitalist system, but it cannot exist by itself and is dependent upon the strength of the manufacturing industry.
The magnitude of the service industry's contribution to United States' GDP, 79.7% in 2014, has provoked alarm that U.S. production is failing. This has not occurred. U.S. has forfeited its first place in industrial production to China but still steadily increases production, 100% since 1980 and 20% after the bottoming in 2010 from the severe recession. The rapid expansion of the service sector and continuous expansion of the manufacturing sector highlights the extent to which much of the American public has been able to acquire sufficient material goods (autos, house wares, electronics) and is able to spend more freely on services (health, entertainment, food).
The statistical representation of the service sector in the GDP is exaggerated. Services can rapidly purchase services that purchase services that purchase services, all purchases being made with the same funds. Dollars transferred from one service provider to others show in Gross Domestic Product (GDP) as several dollars of services. A dollar can only purchase one dollar of goods before that dollar is transferred to the entrepreneur for additional production. The size of the service sector yields clues to economic operations but skews validity of the GDP statistics, whose more important component is the industrial sector.
Full capacity utilization and/or full employment signifies the final reach of the capitalist system -- no more idle machines, no more idle workers, no more additional production and no more additional profits. Not quite. Increased productivity is the accepted means for extending the range of the capitalist system.
In the past, additional profits resulting from productivity were mostly used to raise worker wages. Increasing worker compensation as a direct function of productivity increased domestic consumption and elevated living standards. This practice slowed during the 1980s; after that time real worker wages remained relatively static with entrepreneurs raising prices to offset rising labor costs and strive for additional profits, a lose-lose proposition. By raising prices the aggregate of workers' wage gains are neutralized, which demoralizes labor. The added price forces the entrepreneur to struggle to sell the excess product, usually by increased credit, which brings the profit system closer to collapse.
A compromising method for use of productivity is the lowering of prices. Because this method enables the aggregate of workers in the economic system to purchase more product, lowered prices has an effect that is almost equivalent to raised wages. Another advantage is that it allows the firm to be more competitive, especially for exports and imports. For manufactured goods that are highly elastic, where price changes affect demand, using productivity to lower prices will increase sales and therefore not lower profits. More likely, due to elevated sales, profits will increase.
The true meaning of profit
Profit is perceived with awe, glorified as the deserved result of risky and arduous effort. Household debt is viewed with sympathy, as an opportunity to purchase hard goods and participate in the material life of the nation for those who cannot immediately earn enough to buy the goods. Government debt has severe detractors who consider it a theft on future generations. The true meaning of profit is that they are all the same, the principal component of someone's profit is debt accrued by others.
Regarded as capitalism's nourishment and as an essential motivating factor for industrial leaders, profit has been ill treated by capital. Periodic economic calamities proceed from the belief that profit is unique to a capitalism that decides its direction. A true meaning of profit obsoletes profit's relationship to capitalism.
A socialized system can set aside a surplus and issue credit to those willing to sacrifice immediate satisfactions for amortizing expensive items that would ordinarily require years of savings. This system renovates the chaotic and contradictory movements of free wheeling capitalism. Credit is more highly regulated and prevented from drying up. Profits are recirculated as bonuses to laborers, instead of dividends to stockholders. The profit motive remains but the rewards enrich a greater number of people.
Profit is maximized and more easily sustained when careful attention is given to the elements that restrict it and those who promote it, and when it is used to distribute goods equitably to the entire population. Profit sharing with workers and using productivity to increase purchasing power serve the purpose. These elements need not be imposed; if allowed, they are the natural tendency of the profit system. Profit will rise rapidly and then slow as full capacity of plant and employment approaches, when production and purchasing power are greatest. Although some profit goes to research and development and productivity advances allow more growth, at full employment the system has nothing better to do with profit than distribute it.
Industry wide sharing of profits between investors and employees extends the years between economic cycles and allows stable and high profits -- past year's distributed profit allows purchase of next year's surplus. Less domestic and government credit are needed to keep the system alive. The public enables the capitalist to produce and acquire wealth. The capitalist owes the public much for his/her survival and trying to maximize profits interferes with that survival.
University economic programs have lectured that the obligation of a company is to maximize profits. If all companies tried to maximize profits, they would push the economy to either overproduction in order to elevate revenue or to excessive credit in order to purchase the surplus goods that represent the excessive profit. The entire nation would be washed in unsupportable debt and the system would soon collapse. A preferred purpose for a corporation is to carefully plan for growth and maximum extension of life, which is the aim of all organisms. Finance, as shown, plays the most active role in achieving those aims; regretfully, despite careful planning, individual companies are still subjected to the abuses by the financial industry.
Overleveraging, greed, manipulation, corruption and speculation by national and shadow banks have led to financial collapse. Since the Reagan administration years, a rapid growth of financial sector debt, from $600 billion in 1981 to $15 trillion in 2010 (www.alternativeinsight.com/Deficits_and_Taxes-1.html), pushed money into speculation, failed derivatives and revolving investments and deprived the consumption economy of necessary credit and demand.
The antiquated profit system had one objective -- enriching the capitalist -- which proved to be a boom-and-bust game. The modern system recognizes that profit needs capital as a catalyst and government debt as a ballast to keep the system floating and as reserve energy to prevent a fall in profit from leading to total collapse. Rather than manipulating the system to obtain highest profits, it is preferable to guide the capitalist system to operate with reduced debt and increased benefits for the majority -- guaranteed employment, economic benefits, and financial stability for all citizens.