The Declining Rate of Profit

I keep dinging my Trotskyist friends about the declining rate of profit--magic words they invoke to account for any economic problem at all. It is clear that they generally have no clue as to what that means. But honestly I, too, had no clue what that means, so I thought I'd best go educate myself.

The best source I've found is a conference paper by Michael Roberts, presented in 2011, entitled Measuring the rate of profit; profit cycles and the next recession (pdf). I also looked at two blog posts by Mr. Roberts, here and here. Predictably, there is a huge literature on this topic, and my brief perusal does not qualify me as an expert. So think of this as questions from a novice--for which there are perhaps simple answers--rather than a critique.

The question I always ask my Trotskyist friends is whether by profit they mean operating profit or return on investment--these, of course, are two different things. By Mr. Roberts' account it is some variant of operating profit, i.e., income minus expenses.

Marx's original equation for Rate of Profit (P) is

where s is the surplus value (i.e., what most people would call "profit), c is the total capital stock, and v is the total cost of labor. This is intended to be measured for the entire economy--not just for any individual company.

Mr. Roberts goes through many ways of calculating this equation, but eventually concludes "In my view, the simplest is the best." He measures surplus value as

Or, in words, surplus value is everything left over after depreciation on capital equipment and total wages paid to employees, i.e., something like profit. 

This looks a whole lot like EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, which is the gold standard measure for operating margins. It's not clear to me why Mr. Roberts didn't use EBITDA, but I'll speculate because it's only calculated for individual companies rather than for the economy as a whole. He discusses why he doesn't subtract taxes, but he never mentions interest or amortization. 

That last seems to me to be a very important omission. He does write "But these shorter-length profit cycles are really the product of the running down the stock of working capital (called the Kitchin cycle, named after that economist) and not a decisive ‘turning-point’ in profitability," which sounds like amortization in disguise. He seems to believe that all companies amortize all their equipment at the same rates, i.e., over 16 year cycles, and then replace their equipment at the same time. I find this hard to believe. Why not subtract amortization from the measure of surplus value?

On the other hand, perhaps amortization is better included in the calculation of c--the total capital stock. Mr. Roberts chooses what seems to me to be a very strange measure, namely the cost of plant and equipment at the time of original purchase. Alternatively, other authors calculate c as the current replacement cost, which given inflation will be a larger number. Mr. Roberts argues that latter method misrepresents Marx's original purpose, and from his explanation I agree with him. But either way, to include the cost of capital without including amortization is misleading. Amortized equipment no longer counts as an asset beyond its resale value.

I might disagree with Mr. Roberts on some more general, philosophical principles. This sentence bothers: 

The cause of a crisis like the Great Recession must lie with the key laws of motion of capitalism.

Marx, who lived during an exciting time in physics when both thermodynamics and electromagnetism were completely elucidated, may be forgiven for thinking that economics follows physics-like behavior--some "laws of motion." In fact, economics is more a branch of psychology than physics, for it depends ultimately on what consumers want to purchase. Who would've guessed that the most used part of a mobile phone is not the phone but instead the camera?--a fact that put traditional camera makers out of business. Consumer choices like that have a vastly bigger impact on economics than hypothetical measures such as the "global rate of profit."

Likewise, Trump's biggest impact on the economy was likely not the tax cuts, but rather his bully pulpit--his constant championing about how great things are. It gets the animal spirits flowing. Economists call this "expectations," which is a strange word that understates the effect. Judging from Mr. Roberts' essay, Marxist economists discount expectations and/or psychology altogether, which to my mind means they don't understand economics.

Perhaps as a corollary, if there are no "laws of motion" in economics, then I don't understand the purpose in aggregating the rate of profit across the entire economy. Apple has a very high rate of profit; by contrast Walmart fixes its operating margin at 3%--lowering prices when it goes above that, and closing stores if it falls irremediably below that. What is the point of averaging those two companies together? What do you learn from that statistic? I will argue, nothing.

Finally, Marxists make some very weird definitions. They distinguish between productive employees and unproductive employees. The former are workers who actually sit on the assembly line and make, mine, or grow stuff to sell. The latter are all the others, such as managers, marketers, accountants, professors and real estate agents. Perhaps that made sense in Marx's day when the economy consisted only of commodities. But today 80% of all workers are in services. Are they all unproductive employees?

Walmart is ultimately in the marketing business. Yes, I know they have some trucks and warehouses, but at the end of the day it's all about marketing to consumers. Are all those shelf stockers and cashiers unproductive? I certainly don't think so. People like me would starve to death without the efforts of Walmart workers! (And I depend on their managers, too.)

I think the distinction between productive and unproductive doesn't make sense anymore--at least not in the way Marx understood it.

Marxists consider stock market investments to be fictitious capital, to be distinguished from the real money actually invested in plant and equipment as computed by Mr. Roberts, which they call organic capital. If you're stuck with a just-like-physics view of economics, perhaps this makes sense, but economics is not like physics--it's about psychology. Here is the relevant question: Is company X using its resources--capital and labor--in a way that maximizes benefits for their customers? If the answer is yes, then the stock will go up. If the answer is no, the stock will go down. The problem is that customers are fickle--they may decide they prefer telephones to cameras, or sushi to french fries, or whatever. As consumer sentiments change, then so do investor sentiments, and the stock price varies accordingly, even by the hour.

Unlike what Marxists claim, it is precisely so-called fictitious capital that determines business viability. The total market capitalization depends on the stock price--not the sunk cost of plant and equipment. The relevant measure of profit is return on investment, not some bizarre measure of operating income.

Further Reading:

• Robots and AI
• Let Them Eat Little Bits of Green Paper
• Kim Moody on "Persistent Inequalities"