Profits are Maximizing at the Effective Demand Limit
When Keynes wrote about Effective Demand in Chapter 3 of General Theory… he tied the limit of effective demand to the maximization of profits. Currently I see the economy reaching the effective demand limit by the end of 2014. Is there a sign that profits are maximizing?
Here is Gina Martin Adams of Wells Fargo & Co. from an article at Bloomberg Businessweek.
“The decline in non-financial EBITDA margins is “sending something of an ominous signal” that may be followed by a peak in net-income margins, she wrote in today’s report. “Peak margins were a good indicator of impending recession in each of the last cycles,” she wrote. Sales growth will have to pick up considerably in order to ease concern about margins, she said.”
Time is running out on the bull market.
“Peak margins were a good indicator of impending recession in each of the last cycles,” she wrote.
So am I to understand that in economic thinking when profitability reaches some peak level of performance what comes next is regarded as a recession, with all the negative connotation that the word suggests, rather than a recognition that those “peak” margins were beneficial as they occurred and can only be expected to regress back to some mean point in the economic process?
Jack,
I look at it this way…
When profits rates are rising, firms tend to increase profit rates together. However, when profit rates max, then one firms increase must be another firm’s decrease. The environment is more difficult for marginal firms. Then slowly some firms have trouble creating a slowly building cascading effect where more firms become marginalized because they are connected to more marginalized firms.
Demand has an effective limit. Yet it would be ideal if that limit was stable for firms. Yet it is not. Many firms become vulnerable at the limit due to projections that will not be realized or cash flow projections that start to fall short or other conditions that show firms will not grow as much as thought. In effect firms extended their plans beyond the effective demand limit, and it will come back to bite them in a cascading fashion, unless some things happen with effective demand to forestall the effect.
One lead story this month in the Canadian news magazine Maclean’s asks “Afraid To Be Rich? Why so many are missing out on one of the biggest bull markets in history.” The author, Chris Sorensen, says people were spooked by the 2008 crash, and thus missed “the great bull market almost everyone has missed.” (Query: if everyone missed it, then who were the traders that were riding the bull?)
Sorensen seems to be encouraging ordinary people to “jump in, the water’s fine!” But I’m sticking with you, Ed.
Noni
Hi Noni,
It is good to have corroborating information.
You’ll be right Edward, if the tightening labor market doesn’t result in higher wages and more disposable income and as a result higher levels of consumer spending.
Right now the big thing holding back the economy is the fact that for the most part the recovery has not resulted in bigger paychecks for the middle and working classes.
hi axt113,
Even if wages rise, the limit of effective demand still holds accordingly.
It is getting too late to raise wages. We are too close to the effective demand limit. Profits are in a zero-sum state.
So even if wages rise now, I do not worry about being wrong.
There is a lot of confusion out there about the economy. It seems others do not understand productivity, inflation, unemployment, and the challenges of abenomics. Effective demand makes sense of it all.
Just today I read that real wages fell in Japan recently and abenomics is slowing down.
http://blogs.wsj.com/economics/2014/07/29/abenomics-virtuous-cycle-spinning-more-slowly
It is simple effective demand.
So I will be right if the economy follows the precepts of effective demand, whether wages rise or not.
Effective demand is the missing link in economic theory.
As I said in the other thread on Abenomics.
More people looked for a job in Japan
The number of openings rose, bringing the ratio to 1.10
Minimum wage hikes are entering their final discussion stage for October of this year.
Slowing down of consumer spending is due to the tax increase more than anything.
So I see your concerns as premature.
In addition, I see little evidence that in the US we are too late to deal with the effective demand limit
Assuming such a limit exists, as you haven’t given a sufficient explanation of how we know we have hit the limit, as a reduction in corporate profits can merely mean that corporations, which have relied on reducing costs for so long, by cutting payrolls and trimming unprofitable divisions, have hit a point where they must expand their capacity and labor force, enter new markets, seek out non-consumers and former consumers of their products their industry makes, etc.
What you define as the effective demand may just be a sign that corporations have gone as far as they can go with regards to cost cutting as a strategy.
(as an example, with video game companies, there are markets they are not as active in, such as China and India, and consumers who don’t play video games, or those who used to play video games who have dropped out of the market due to lack of interest in the products currently offered at current price points)
In addition, I still question your assertions that an increase in aggregate capacity and aggregate demand will not increase the level of effective demand, and am still waiting for an explanation of your theory on these two issues.
Axt113,
Let me give a quick look…
Let’s say that you can produce 20 units at full capacity. Yet demand can only be 16 at max since labor is paid 80% of total income.
As long as you produce below 16, you have power in the market to generate profits from labor. So if you produce 13 for example, there is more demand out there to raise the price.
Yet if you tried to produce 18 units, you would lose power in the market. That is when your profits start to decrease.
The key is knowing what production would be at full capacity in terms of utilization of available labor and capital. I see productive capacity as stable attractor state for most of the business cycle. It is now trending toward $21.75 trillion. Link…
http://angrybearblog.strategydemo.com/2014/06/attractor-states-in-biz-cycle.html
You might see productive capacity as changing through the business cycle. But my model sees it as stable. When productive capacity rises off its attractor state is the time to watch very carefully the economy.
Why would productive capacity be stable?
Every new road, rail, factory, airport, etc is more capacity.
If I can only make 20 units max, but then add another factory that allows 20 more units, why wouldn’t that change the situation in the model.
Axt113: Capacity to produce is one thing, size of market is another. If my factory can only sell 18 units, and can reasonably run a profit making and selling 13 units, then why on earth would I build capacity to 40 units? I would either be left with an extra 22 units gathering dust, or sell them at cost and undercut myself, just to clear them out of the warehouse. Yes, manufacturers do this sometimes by accident or as a market strategy, but as a regular business practice it cannot work.
It would be interesting to look at the economies of the pre-Civil War south, especially those counties where the great majority of the people were slaves, presumably with little or no spending money. The shape of such an economy would be very unlike a free economy, very constipated, I would guess, although possibly more stable.
Noni
If aggregate demand is rising, then that means a larger potential market.
Think of it this way.
If I’m selling a new video game system, and currently only 10 million can afford it, but then wage growth occurs, and now 50 milluon can afford it, why wouldn’t I try to reach at least some of those 40 million potential new customers?
Even if I only increased capacity to 30 million, not only would I still be able to profit, but the market would be far larger.
Like I’ve been saying, your theory hinges on wages staying stagnant and choking off a rise in aggregate demand.
Should wages and consumption grow, you’ll see the economy break out.
The next 6-8 months is key for the US, I think, if the economy hasn’t broken out by early Q1 2015, it won’t.
axt113,
sorry I am getting back late to answer…
I say productive capacity is stable from the model of real GDP (y axis) and utilization of labor and capital (x axis).
http://angrybearblog.strategydemo.com/wp-content/uploads/2014/06/attractor-PC-shifts-beyond.png
You will see in the graph that the plot will move straight up the sloping line toward a stable level at 100% capacity.
There is a productive capacity that the business cycle forms around. Then labor and capital are used toward that productive capacity almost in spite of new investments. Those new investments will show up in the following business cycle when real GDP starts heading toward a higher stable productive capacity for that business cycle.
Noni,
Agreed… it would be interesting to study the economy of the Pre-civil war south. Was there an effective demand? Who were the buyers of production? How did alternative currencies function? How much bartering was there among labor? How did money circulate? Among who did money circulate? And to what extent was the system stable?
axt113,
sorry again for replying late…
The economy did break out of the effective demand limit back in the late 90s. Just when real GDP hit the ED limit, labor share began to rise, productivity began to rise, capacity utilization began to decline and unemployment came down some more.
The real key is that the productivity gains were going into labor income nicely. That kept the economy growing, even though real GDP never really broke through the effective demand limit.
So my theory does not hinge on wages staying stagnant. Wages can rise and my theory has held in the past. When wages rise and labor share rises, there is more effective demand.
Yet a key understanding of effective demand is to know the optimal balance between labor and capital shares. Labor share can be too high.
Yet I totally agree with you about the US economy breaking out by mid 2015, or else it is trapped in the limit.