# Estimating profit rates of capital

The principles of effective demand can be used to evaluate the aggregate profit rate on capital. This measure is a useful indicator of the business cycle. When the aggregate profit rate gets sluggish or falls, the economy is tempting a recession.

The basic equation to determine the aggregate profit rate on capital is…

Aggregate profit rate, r = (1 – effective labor share) * real GDP/value of capital goods

This equation is simply based on the equation for capital share of income…

Capital share = profit rate * capital goods/real GDP

Capital income = profit rate * capital goods

We already know the values for effective labor share and real GDP. (Graph of data for effective labor share.) All we need is a value for capital goods. I go to table 9.1 at the BEA’s Fixed Assets Accounts Tables. Then I use line #2, Private & Government Fixed Assets, as the value of all capital goods. (The table currently has the numbers in 2005 dollars, so I convert to 2009 dollars by multiplying by 1.09.) Here is a graph of the value of capital in the US since 1996 in 2009 dollars. (quarterly data)

The growth trend in capital formation was faster before the crisis. The blue line shows actual data, which the BEA gives up until 2011. The orange dots are projected data for capital that I use to calculate the profits rates up until the 2nd quarter of 2013.

Here then is the graph for profit rates since 1996.

In the aggregate, we can see that profit rates peaked in 3rd quarter 1997, which agrees with a graph from Samuel Bowles’ book, Understanding Capitalism. We can see that profits rates dropped until the end of the 2001 recession… and then started rising fast through the bubble years.

The dashed red line shows the 1 year moving average for profit rates. We can see that profit rates were stuck for 2 years before the 2008 crisis. One could have seen here that a recession was likely. When profit rates are seen along side the consumption rate of capital income, the picture gets clearer to forecast a recession.

I see a pattern where capital income’s consumption rate rises really fast after the profit rate has been rising steadily for a couple of years and then begins to taper off. Behaviorally, I see capital income being spent on consumption as the profit rates are seen as peaking. The profit rates head downward and capital income starts to protect itself by not over-extending its consumption. As the profit rate stays “sluggish”, less and less capital income is used for consumption.

Keynes saw that profit rates were important to determine the volume of employment, as well as the point of the effective demand limit, which points to the moment of a recession starting.

“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**.” (source)

Some economists thought the economy was on the verge of a recession in 2011. There was a brief stalling of profit rates and capital income’s consumption rate. But the economy pulled up from there. The economy will wait until the effective demand limit before going into a recession, with the exception of the Volcker recession.

Something to keep our eyes on is that the profit rate tends to flatten out before capital income’s consumption rate starts to fall. And it sees as though profit rates are currently flattening out.