Tuesday, January 19, 2016

The Corporate Religion (Part 2: The Profit Problem)

John Hobson, a frail little Englishman with a speech impediment and a penchant for economic heresy, argued more than a century ago that in order to grow, indeed, in order to survive, capitalism had to become imperialistic. Without exporting both production capacity and products abroad, capitalism would eventually suffocate itself. At the time, no one really took him seriously, except the Marxists, who twisted his ideas into a strange confirmation of their own misconceptions. But Hobson’s reasoning was both fascinating and deceptively simple: growth, the very engine that drives capitalism, also creates the conditions in which a nation can never consume everything it produces.1
The poor, Hobson argued—and today we would add the middle class—don’t have the means to buy their fair share of the nation’s production, and the rich have too much money to consume a proportionate piece of the productive pie. Someone with a $10 million income can’t (or won’t see any reason to) buy two hundred times more consumer goods than a person with a $50,000 income. In fact, the wealthy in every society are mindful of what they don’t spend, for if they spend all they have, they are no longer wealthy. Wealthy people, rather than spend most of their income, invest a good portion of it, directly or indirectly, in new productive capacity, which, Hobson insisted, merely compounds the problem. If society is already having difficulty consuming all it produces, then this perpetual increase in productive capacity will flood an already saturated market.
In order to grow, Hobson concluded, capitalist economies not only have to invest their capital abroad, they also have to sell their increased production abroad. They have to export more than they import. From one nation’s perspective, this provides a temporary respite, but in the long run it ruins a world economy, as more and more nations need an outlet for their excesses.
Hobson’s ideas, though largely forgotten, are nonetheless significant, especially when seen in light of today’s global economy. For many years after World War II, America was able to export more than it imported. But now the tables are turned. For decades now, America has run up huge trade deficits. In other words, we have somehow found a way to consume not only everything we produce, but billions of dollars of goods imported from other countries. How have we managed this?
It is simple, really. We have found a way around Hobson’s insistence that capitalist societies cannot consume all they produce without becoming imperialistic: debt. We are buying on credit. The problem with this solution is obvious: eventually, as the world economy reaches the point America reached a few decades ago and all nations sink deeper into debt, the global economy will bankrupt itself. Because of the principle of compound interest, debt has a tendency to grow exponentially and, in normal times, to outpace economic growth. At present, interest rates are abnormally low, so we are experiencing a brief reprieve, but, as they say, time will tell.
The root of Hobson’s dilemma, though, is the unequal distribution of wealth. If the lower and middle classes had more disposable income with which to purchase consumer goods, and if the wealthy had less excess money to invest in unneeded production, would the system avoid its inevitable demise? This is a good question, which lies beyond the scope of this series of posts. For now, we need to address the question of profit.

The Profit Problem
John Hobson’s intriguing observations hint at the underlying question introduced in the previous post: What makes the capitalist economy grow? The answer is simple: profit. But where does profit come from? Profit in a single business is, of course, the difference between revenues and expenses. It comes simply as businesses charge more for their products than the sum of their expenses. But the aggregate of all businesses should not be able to experience a profit because all revenues and expenses should cancel each other out. This is the problem that perplexed worldly philosophers for centuries. Curiously, only three reasonable answers were ever put forward: one by Karl Marx, another by Joseph Schumpeter, and a third by Thorstein Veblen. Even the venerable Adam Smith wavered on this question between two possible answers.
For a detailed explanation of the three theories, I recommend Robert Heilbroner’s classic The Worldly Philosophers, but for our purposes here, let me try to fit these three explanations into a very small nutshell. Marx concluded, as did others, that profit doesn’t occur naturally in the capitalist system. Market forces drive profit from the system whenever it rears its head, so Marx theorized that the only way capitalists can extract a profit from their operations is to steal it from the laborers by paying them less than their actual value. This theory has some merit but also some obvious limitations, since it doesn’t address the reality Hobson identified or answer the question posed by Hannah Bell (see last week’s post).
To Schumpeter, profit was not stolen into existence; rather, it came honestly from innovation. He described production and consumption as a circular flow that follows a regular and predictable course: people trading money and products with one another. Profits magically appear whenever innovation disrupts the circular flow. Those who create the innovation can charge a higher price or reduce their production costs and thus extract a profit—until their competitors match the innovation and restore equilibrium. Schumpeter’s theory offers a partial explanation, but it still does not answer Hannah Bell’s question. Innovators may be able to charge more for their products temporarily, but their revenues must still come from somewhere, and that “somewhere” is, directly or indirectly, someone else’s expense, so revenues and expenses still theoretically cancel each other out.
Veblen came at the profit problem from a different angle. He saw “the economic process itself as being basically mechanical in character. Economic meant production, and production meant the machinelike meshing of society as it turned out goods. Such a social machine would need tenders, of course—technicians and engineers to make whatever adjustments were necessary to ensure the most efficient cooperation of the parts.”2
But where, asked Veblen, does the businessman fit in? The businessman, he concluded, was basically a saboteur of the system who extracted profit by disrupting its smooth, mechanical operation. The system saw no other end except making goods. But the businessman was interested only in making money. The problem with the economic machine, however, is that if it worked efficiently, there would be no room for a man who only wanted to make a profit, because profit would be squeezed out of the regular flow of production and consumption. “So the businessman achieved his end not by working within the system, but by conspiring against it. His real purpose was not to help make goods, but to cause breakdowns in the regular flow of output so that values would fluctuate and he could capitalize on the confusion to reap a profit.”3
And how did the businessman cause these breakdowns in the production machinery? By creating the never-never-land of corporate finance. Corporate capitalism isn’t just about producing motorcycles and mushrooms and microchips. “On top of the machinelike dependability of the actual production apparatus,” writes Heilbroner, explaining Veblen’s theory, “the businessman built a superstructure of credit, loans, and make-believe capitalizations. Below, society turned over in its mechanical routine; above, the structure of finance swayed and shifted. And as the financial counterpart to the real world teetered, opportunities for profit constantly appeared, disappeared, and reappeared.”4

The Disconnected Financial System
All three of the theories about where profit comes from in the capitalist system—the theories of Marx, Schumpeter, and Veblen—have their merits, but they also have significant flaws. Indeed, none of these theories actually explains how the capitalist economy expands and produces profit. Veblen’s version, for instance, doesn’t really explain how ordinary businesses that aren’t involved in financial manipulations can turn a profit, but it certainly addresses what has been happening recently in the global economy at large. As Wall Street has concocted a variety of “make-believe capitalizations,” the financial sector has found ways to extract obscene amounts of “profit” from the economy. In 2007, for instance, just before the big financial meltdown, the top fifty private investment fund managers received an average of $588 million each in annual compensation. The top five received more than $1.5 billion each.5 And this is just the tip of the iceberg. These firms were extracting phantom profits and paying out salaries and bonuses in unheard-of quantities. Of course, when this house of cards collapsed, it became obvious that these profits and outlandish compensation packages were simply the effect of leveraging assets to the moon and back through speculative financial instruments called derivatives. And since so much money had been paid out in salaries and bonuses, there was not nearly enough left in reserve to cover the losses, which compelled government to step in with enormous bailouts to keep the entire economy from falling apart. Of course, the recent Republican claims that we shouldn’t have bailed out Wall Street are simply the blather of politicians who have no concept of what would have happened if we hadn’t.
The idea of the bailouts was to clear out toxic debt and get credit flowing again so that the economy could return to its normal course of endless growth. But the debt this debacle has added to the system will simply hasten its demise, necessary though it was. The crisis of corporate capitalism, to put it bluntly, is not something we can grow out of, because growth is funded by debt. And in order to grow the economy faster than it could possibly grow in the normal course of business, Wall Street piled up layer upon layer of debt to leverage any real assets at the bottom of the pile far beyond the point of no return. Indeed, those real assets were buried so far beneath the pile of debt that they were almost completely forgotten, and were virtually meaningless to the Wall Street Rumpelstiltskins who were busy spinning gold out of straw.
Aside from the suffocating quantities of debt the system has generated, 2008 brought the distinct possibility of “sudden death by derivative.” The world economy came closer to collapse than most people realize. And we have not corrected the systemic flaws that pushed us to the precipice. According to figures published by the only institution that tracks the derivatives market (the Bank of International Settlements), the size of that market—consisting of both over-the-counter and exchange-traded derivatives—exceeded $1.1 quadrillion in July 2008.6 Yes, quadrillion. More recent estimates put it now at about $1.2 quadrillion. By contrast, the value of the world’s financial assets—including all stock, bonds, and bank deposits—was pegged at $294 trillion” in 2014.7 In other words, the derivatives market is four times as large as the world’s combined financial assets. But these financial instruments are not like stocks or bonds, and they certainly have little similarity to bank deposits. Even though David Korten has labeled them “phantom wealth,” they are massive in quantity and frightening in their destructive potential.
The derivatives market is something akin to a global casino. It consists of bets financial speculators place in hope of winning the jackpot. These “investors” can bet on anything from the future price of crude oil to the financial solvency of the Port Authority of New York and New Jersey. Derivatives also include insurance contracts on regular financial instruments such as corporate bonds. The problem with derivatives is that they are highly leveraged, meaning that a small foundation of real assets supports an immense tower of speculation. This is the bubble that almost popped in 2008. In March of that year, Bear Stearns, with derivatives valued at $13.4 trillion (larger than the U.S. national income), almost failed. Because the financial sector is so interlinked, this would have caused a complete systemic collapse. Disaster was averted because the Fed allowed J .P. Morgan Chase to add the endangered Bear Stearns derivatives to its own $77 trillion portfolio.8 Then, in September 2008, AIG and its derivatives—called credit default swaps—almost sank the whole financial sector.9
Investment sage Warren Buffett had good reason to call derivatives “financial weapons of mass destruction.”10 “We view them as time bombs,” he wrote, “both for the parties that deal in them and the economic system.”11 This was five years before the 2008 meltdown, which would have been catastrophic without government intervention. But the derivative bubble still exists, and even though Congress enacted a little bit of financial reform, the market is still largely unregulated and highly leveraged, and the reckless Republicans want to deregulate the financial sector even more. Go figure.
When we look at the sheer size of the derivatives market, compared with the size of the world economy ($107.5 trillion), it is easy to see where so much of our profit has come from. It is phantom wealth that has been conjured into existence by leveraging real assets far beyond their ability to ever provide the necessary level of return.
What is happening on Wall Street and elsewhere is very consistent with the ideas of Veblen, who theorized that profit is the result of financial manipulations by businesspeople who sabotage the system. The problem with this method of creating profit is that it divorces the financial system from the apparatus of production and consumption and makes profit an end in itself. In Veblen’s world, most of the goods that clamor for our spare change (or remaining credit) are not an end in themselves, items that people actually need or that improve their lives. Most of the products sold in today’s market are means to an end, and that end is profit. They were created not because we need them or even want them, but so that someone could extort a profit from the flow. We are then persuaded through advertising that we do indeed need or want them. In the process, production has become a tool of finance, not the reverse.
Finance as an end in itself is a scary thing. When money becomes the most sought-after product, something is terribly amiss because money is no product at all. Money is a tool, a pure fiction we created to ease the exchange of real products and labor. According to John Stuart Mill, “It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it; and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.”12
Money in our day has indeed gotten out of order. Because the financial superstructure is so divorced from the practical economy, implausible profits have been reaped and impossible though imaginary financial growth has been experienced. But, as we have seen all too clearly, this incredible profit and growth was really nothing more than a bubble. It popped once. And what did we do about it? Did we put limitations in place that would prevent another crisis? No. We restored the same flawed system, slapped its wrist, and now the Republican Congress wants to turn it loose to do what it is designed to do. We have created the perfect conditions for another bubble and another collapse.
1. For a summary of Hobson’s argument, see Robert L. Heilbroner, The Worldly Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers, 6th ed. (New York: Simon & Schuster, 1986), 194–200.
2. Heilbroner, The Worldly Philosophers, 235.
3. Heilbroner, The Worldly Philosophers, 235–36.
4. Heilbroner, The Worldly Philosophers, 236.
5. Sarah Anderson et al., “Executive Excess 2008: How Average Taxpayers Subsidize Runaway Pay,” 14th Annual CEO Compensation Survey (Washington, DC: Institute for Policy Studies, 2008), 3.
6.  Jutia Group, “Global Derivatives Market Now Valued at $1.14 Quadrillion!” iStockAnalyst, http://www.istockanalyst.com/article/viewarticle/articleid/2432853/. More recent estimates peg total derivatives at $1.4 quadrillion, ample proof that indeed we have not corrected the flaws that allowed the speculative bubble that almost destroyed the global corporate economy in 2008.
7. Sam Ro, “Here’s What the $294 Trillion Market of Global Financial Assets Looks Like,” http://www.businessinsider.com/global-financial-assets-2015-2.
8. Jutia Group, “Global Derivatives Market.”
9. If you’re interested in learning more about how derivatives work and why they almost brought the house down, a good place to start is Adam Davidson, “How AIG Fell Apart,” http://www.reuters.com/article/idUSMAR85972720080918.
10. Berkshire Hathaway Inc. 2002 Annual Report, 15.
11. “Introduction to Derivatives,” Global Derivatives, http://www.global-derivatives.com/index.php?option=com_content&task=view&id=185.
12. John Stuart Mill, The Principles of Political Economy, 9th ed., (London: Longmans, Green & Co., [1848], 1886), Vol. II, Book III, Chap. VII, p. 9.


  1. A scary thought, and I think reality. To me you make a compelling case that the financial system is out of whack, and in need of serious regulation. Speculation / the derivatives market it seems has become a monster and needs to be put back in its place. I'm not an economist, but I would think by creating a ceiling/cap on profit that can be obtained through financial trade, then efforts could be realigned to where they can produce actual value. Just throwing out random numbers, but for example if one could make $50 million/year in trading, but it were capped at $1m, surely there is still enough incentive that someone would do the job that would continue to provide the balance value that financial trading market creates. Wallstreet being capped at 1/100th of it's current unregulated potential for example, I don't believe would change much of it's value output to society at large.

    My shot at an answer to your earlier questions is that in a functioning system, profits are reaped from value creation. And value is a product of work. The resources on earth left alone have a certain value, throw in work you can turn those resources into something of greater value, and with value creation or the creation of wealth, profits can be reaped.

    However, I agree with the idea that within the derivatives market and throughout the financial system there seem to be many market inefficiencies that left on their own are pulling profits not from true value creation, and are therefore destroying the system, hence the need for regulation. It honestly seems like too big of a problem that I feel I can do anything about it. A bubble and a pop of that bubble almost feels inevitable. It's a depressing thought, but I don't know what else I can do besides go on my way and hope for the best.

  2. How about instead of stumbling around in the mists of darkness you read some real economists like Mises or Rothbard who hone in on the truth. You could start with Human Action or Man, Economy and State or The Theory of Money and Credit. All are available for free on mises.org.