More on Breaking the Code between Effective Demand & Profit Margins
My previous post talked about how profits peaked 12 months ago coinciding with the economy hitting the effective demand limit. The idea is that profit margins will peak at the effective demand limit. Keynes stated this…
“Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.” (Chapter 3 of General Theory, Keynes)
So if we can make a tie between a measure of profits peaking and an effective demand limit, we have a chance to break the effective demand code.
The Problem of not knowing the Effective Demand Limit
In the late 1990’s, there was a problem. From the book, Asset Prices and Monetary Policy.
“If you look at the evidence from the period, it is quite striking. Corporate profit margins peaked in 1997. But the earnings expectations of equity analysts kept increasing until the stock market bubble collapsed… Clearly the behavior of profit margins and equity analyst expectations were inconsistent.”
If equity analysts had a measure of effective demand to determine when profit margins peak, their expectations would be more consistent with reality. So breaking the code of Effective Demand to know when profit margins peak (as Keynes saw it) should make the market function better…
Making the Ties
Do we have ties between profit margins peaking and a measure for Effective Demand? Yes… From the previous post, we have the tie 12 months ago. We have a tie in 1985. We have a tie in 1989… but I failed to mention that we also have 2 ties in the 1970’s, 3rdQ 1997 and 3rdQ 2006, when profit margins also peaked. In those times, the economy also hit the effective demand limit.
I circle the times when profit margins peaked and the economy also hit the effective demand limit. Every single business cycle. (I also include 1985 as an example that did not lead to a recession because the effective demand limit had not been reached yet.)
Here is a graph of profit margins for reference. You want to look at the blue line. (link)
Measuring the Effective Demand Limit
The effective demand limit is measured by this equation as it goes to zero…
labor share: non-farm business sector * 0.762 – capacity utilization * (1 – unemployment rate)
It is an equation that measures the difference between labor share and the composite utilization of labor and capital.
It seems that this simple equation breaks some part of the effective demand code. If this equation for effective demand was known back in the late 90’s, maybe more analysts would have stopped expecting higher profit margins. The bubble would not have blown up so much.
and what about now?… How many equity analysts expect profit margins to start picking up again?
I do not trust their expectations.
I thought that maybe this article would ignite some comments because it really does break a code that could affect how stock markets operate. If analysts really can determine when profit margins peak ahead of time and in real time, the stock market would eventually behave differently.
The post gives proof of an effective demand limit upon profit margins. And that limit is established by labor’s share of income.
Just imagine Wall Street talking more about labor share as the limiting factor on economy potential.
Is that too futuristic?
“I circle the times when profit margins peaked and the economy also hit the effective demand limit.”
I don’t understand. I thought hitting the effective demand limit meant getting down to zero on the chart. But in 1985 it does not.
After rereading and going back to the previous post I get it. I suggest that if you want to reuse the chart, you think about marking the positions on the lower chart as well. Also using a different color and perhaps more explanation about why 1985 had a profit margin peak (which I got to by listening to the video in the older post).
It seems you might want to expand on what is similar and what is different about the time between reaching the ED limit and the start of each of the recessions.
from your rcube link:
“There is a simple economic explanation for the mean‐reverting behavior of corporate profit margins: low profit margins lead to business failures, reduced competition, resulting in increased profit margins for surviving businesses. Inversely, high profit margins lead to overinvestment, which erodes profit margins further down the road. In other words, fluctuating profit margins are consubstantial with capitalism and the business cycle.”
Another explanation is that the process of maximizing profits cannibalizes the funds of customers by paying workers less.
Hi Arne,
I hear you… The lower graph should have markers that correspond to the upper graph. I aligned them in size so that the peaks kind of lined up, but I guess it wasn’t enough.
How much time from peak profit margins to recession?… the rule of thumb is like 2 years. So the US would be in a recession late 2016 if the rule of thumb holds.
I saw the about 2 years, but I meant what was different about what was going on during that time.
1980: Stagflation, Volker intervention
1990: did not reach ED, but savings and loan blowup tipped things over
2000: Was the start of dot-com runup the cause of reaching ED, or was it a temporal coincidence? There was real job expansion well beyond anything before or since.
2007: People forget recession preceded financial crisis. Path to ED was impacted by debt.
2016: I see less impact from employment to spending. Will this be a slow motion recession?