Home > Uncategorized > Reversing India’s falling growth rate

Reversing India’s falling growth rate

 

The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.
–John Maynard Keynes

Where do business profits come from?

 

It is remarkable that in an age dominated by Capitalism, capitalistic theories of economics have so little to say about the very force that motivates all entrepreneurial activity – the quest for profits!  Micro-economic theory briefly ventures into the field. But what is true for an individual firm is not necessarily true for the economy at the macro level.  What then drives aggregate business profits in an economy?  To the extent investment is predicated on expectations of future profits, and investments determine growth in GDP of developing economies like India, you would think this question would be at the heart of policy formulation.  The sad fact is such considerations don’t figure in policy making because mainstream economics lacks a theory of profits!  Worse, and with no apologies to Ayn Rand fans, to understand where profits come from one has to turn to Karl Marx, and a later day Marxist from Poland, Michal Kalecki, for a workable theory of profits.

 

Marx’s insight into the source of profits comes from his studies of money.  Simply put Marx said an entrepreneur invests M amount of money to buy a commodity which he then attempts to sell at a higher price M’, the difference between the two being profit.  But he lost his way in metaphysical questions surrounding value and ended up ascribing all value as being created by labour which the entrepreneur “unfairly” captured.  Michal Kalecki started with Marx’s original insight and ended up holding that business profits are nothing but the original money spent by the entrepreneur returned to him if he is clever enough to capture it. One can summarize his theory in two statements: Firstly, workers as consumers spend what they get. Secondly entrepreneurs get as profits what they spend. The model is explained well in the references below. For our purposes the model may be stated as:

 

Pn = I + [G-T] + NX + Cp – Sw

 

where Pn is the gross profit of all businesses after tax, I is the investment made by all firms in the economy, [G-T] is the Government deficit representing the difference between Government spending and tax receipts, Nx is net exports, Cp is consumption by entrepreneurs themselves [think capital flight] and Sw is the aggregate saving of all workers in the economy. What we are basically saying is aggregate profits earned by firms in any economy are the sum of investments made by them plus net contribution to the pool of profits by Government, earnings from exports less what is put away for a rainy day by workers who refuse to spend all they earn.  Cp is usually very small at the macro level unless you think of capital flight from an economy.

 

Now we have basically turned economic theory on its head. Yet ask any entrepreneur and he will vouch for the truth of the above equation. Why do neoclassical economic theorists gloss over the central role of business profits in macro-economic theory?  That is well beyond the scope of this article here but I refer you to the blog below. Briefly, if you take business profits into account then the so-called stability of the economy as whole falls apart. So for the moment we will simply use the above Kalecki equation to look at what might be done in order to arrest and reverse the falling growth rate in the Indian economy.

 

Let us begin by noting what is not in the equation.  That by  itself is remarkable.  Inflation doesn’t figure here, neither do interest rates.  What matters first and foremost is investment by businesses themselves. When investment falls, business profits fall, and when expectations of business profit fall, investment falls even more, setting up a vicious downward spiral.  Note the direction of causation. Profits are caused by investment. It is simply what businesses spend that is returned to them. Second, budget deficits are good for profits.  Any entrepreneur worth his salt will tell you that. He doesn’t mind inflation either as long as it doesn’t destruct demand. Interest rates are irrelevant from a macro perspective as long as aggregate demand holds up. It is the absolute value of money added to the profit pool that matters for business profits.

 

Net exports add to the profit pool because the workers and investment used to create the export goods are in the local economy while the money that pays for them comes from abroad. Exports earnings contribute to the profit pool.  Conversely imports take away from the profit pool because the money to pay for goods and services takes away from the local spending. So if an economy is running a current account deficit, like ours is, the deficit takes away from the profit pool and must be compensated for by a matching Government deficit or the economy would spin into a deflationary spiral.

 

Lastly consider the matter of workers’ savings. To the extent they save, the total pool of profits available to firms diminishes.  Now you know why firms don’t want you to save and bankers actually drive you into debt.  Savings a just bad news and if workers save the Government must offset the savings by spending if firms are to recover their investments.  If workers save, and Government doesn’t offset that by spending itself, you risk the dreaded deflationary spiral of death.

 

Seen in light of the Kalecki equation, why has the Indian growth rate dropped to 7% from 9% earlier?  Among the many factors that one can think of 3 that stand out for policy action.

 

Firstly, expectations of profits have fallen because of worldwide deflation reducing investment. Government needs to step in boldly by reversing those expectations by stepping up its own investment in infrastructure. The deficit it creates is good for business profits and catalyzing more investment by private firms. Corruption, bottle necks in land acquisition, red tape etc are often cited as contributing to the slow down. That wasn’t true of China and isn’t true of India. What matters is Government willingness to invest in infrastructure by itself or catalyzing such investment through State owned institutions as in China. Firms will look at the size of profit pool available: either made available by Government or by the investments made by fellow firms. That is a searing insight provided by the Kalecki model.

 

Secondly, India’s savings habbits are dangerously deflationary, especially the recent upsurge in savings through investment in gold. Gold imports take away from the profit pool through imports. It is a double whammy. Not only must Government offset these savings by a matching deficit but also the asset created contributes nothing to local spending since gold is imported. Government would do well to tax gold and offer matching tax concessions on housing to promote domestic growth as housing is an attractive hedge against inflation, is not imported and contributes to local spending compared to imported gold. Savings by investment in housing add to the profit pool since to firms that saving is also spending. That policy reform brookes no delay.

 

Lastly, our slow down has been caused by growth hitting supply side capacity constraints caused by paucity of Government investment in areas of infrastructure that it insists on controlling. It isn’t lack of demand: latent or otherwise. Our inflation level reflects the friction of capacity constraints in agriculture and infrastructure that need supply side policy changes rather than tighter money and higher interest rates. Government must address the root cause of inflation which is underinvestment in agriculture and infrastructure.

 

http://www.nakedcapitalism.com/2011/08/philip-pilkington-profits-in-a-capitalist-economy-–-where-do-they-come-from-where-do-they-go.html

 

 

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Categories: Uncategorized
  1. February 3, 2012 at 1:19 pm

    Quite an insightful article, you make a very essential point of the similarity and the dissimilarity between India and China, red tape, corruption is rampant in both the countries, however, China has a higher GDP growth than India, that is because as you rightly pointed out investment in infrastructure. If the Indian government seriously starts investing in developing infrastructure, lots of our problems (especially of wastage of agricultural produce) will get solved.

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