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.

profit peaks UT index 2

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)

profit peaks

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.