Tuesday, January 26, 2016

The Corporate Religion (Part 3: Where Profit Comes From)

In the first post in this series, I introduced the question that has perplexed worldly philosophers for centuries: Where does profit come from in a capitalist economy, or, in other words, where does growth come from? Some economic thinkers have suggested what I brought up earlier—that logically there should be no profit in an efficiently functioning market system because revenues and expenses in the aggregate should cancel each other out and market forces should pressure both prices and wages into an uneasy truce. This is generally true, but, in addition to the financial shenanigans addressed in last week’s post, there are three notable mechanisms that disrupt the normally seamless interchange of money, goods, and services that produces a profit-free system of mutually canceling expenses and revenues.
Inventory. Because most businesses use the accrual method of accounting, revenues and expenses do not line up exactly over time. To illustrate with a simple example, revenue is realized by a producer when its product is sold to another company, perhaps a retailer, who then places it in inventory. But the retailer does not recognize this purchase as an immediate expense. The cost of this product is not recorded as an expense until it is sold to a consumer. So the revenue experienced by the producer and the expense recorded by the retailer may actually happen in different years. If inventories increase over time, the natural result for an entire economy featuring such transactions is profit. This is an example of how growth and profit are dependent on each other.
Capital assets. Some purchases are significant enough that they are capitalized and then depreciated over time instead of being immediately expensed. For example, if a business purchases a new office building, it does not immediately write the new building off as an expense, although the seller may record the sale as immediate revenue. Generally, the expense for these large purchases is realized over time as the asset depreciates. Again, revenues for one company and expenses for the other party in the transaction do not align. And if asset values increase over time, the economy grows.
Purchasing with debt. Whenever purchases are made using debt—either one business from another or consumers purchasing from a business—a similar misalignment of revenues and expenses occurs. The seller recognizes the sale immediately as revenue (if the credit is provided by a third party), but the buyer doesn’t recognize the expense all at once. That expense is spread over the life of the loan and generally takes the form of installment payments. To use a familiar example, when I purchased a car a few years ago, the auto dealer received full payment the day my credit union transferred the funds. But for me, since I am not independently wealthy, this was not a one-time expense. My expense was spread out over five years and occurred in manageable monthly installments. And what about the loan from the credit union? How did the credit union experience its expenses and revenues? Well, that is another story altogether, which I will address shortly.

Money, Money, Money
The three exceptions mentioned above are helpful in explaining how a capitalist economy grows, but in no way do they come close to accounting for all the profits that are extracted from the flow of goods and services. So, what else may account for this expansion? One pivotal mechanism that makes growth possible is the expansion of the money supply. If the money supply does not expand, the economy simply cannot grow. (This, by the way, was the fatal flaw of Hannah Bell’s two-company economy: a static money supply, which made profit impossible.) So, how does the monetary supply expand? There are perhaps three ways. I say “perhaps” because one of these ways is an illusion.
First, the government prints money. If you listen to politicians and some journalists, you get the impression that when government needs more money, it simply cranks up the printing press. But printing money is actually a very minor source of new funds, primarily because so few of our financial transactions involve federal reserve notes (cash) in this digital age.
A much more fertile source of monetary growth is the financial sleight of hand that takes place whenever commercial banks lend money into existence, and this is the answer to the credit union question above. According to Herman Daly and John Cobb, “Private creation of money by banks evolved long before it was understood. Joseph Schumpeter claims that, as late as the 1920s, ninety-nine out of one hundred economists believed that banks could not create money any more than cloakrooms could create coats.”1 Although this practice was not well understood for years, today it is fairly common knowledge. Anyone who has taken an elementary economics course should understand it. Basically, if a bank is required to keep only 10 percent of its deposits on reserve, it can loan out $90 of a $100 deposit. If the recipient of the $90 loan deposits the whole amount in his bank account, that bank can loan out $81, and the process then repeats itself again and again. The potential new money from this lending practice is $1,000. This new money, in general, is used to produce products, purchase products, and generate revenues. As the revenues return to the banks to pay off the loans, the banks skim off interest, which becomes their profit. Of course, the lower the reserve ratio, the more the initial asset can be leveraged and the more interest will be charged. The key to growth, then, is for banks to keep lending money, preferably in forms that have low reserve requirements, and to make sure that aggregate net debt increases over time.
The reserve ratio for banks in the United States varies depending on the institutions’ volume of transactions and type of deposits, but it ranges between zero and 10 percent and excludes such ordinary categories as savings accounts, CDs, and time deposits from corporations and foreign governments. What this means is that financial institutions can leverage a good portion of their deposits at astronomical rates. But what about the bizarre financial instruments concocted by Wall Street? Well, they have not been regulated at all. This is how Lehman Brothers was able to leverage its assets at a 35 to 1 ratio. And, of course, as financial institutions create this inverted pyramid of debt, they charge interest or fees at every level. This is why banking is so profitable.
Daly and Cobb question the whole notion of compound interest, insisting that “money should not bear interest as a condition of its existence, but only when genuinely lent by an owner who gives up its use while it is in the possession of the borrower. When the commercial banking system lends money, it gives up nothing, creating deposits ex nihilo up to the limit set by the reserve requirement.”2 And if there is no reserve requirement, the sky is the limit, until the air gets too thin and the balloon collapses.
The third way new money is created (and at least some people subscribe to this theory) is through the bidding up of asset values by speculation. The stock market is only one element in the vast array of assets that attract speculators, but understanding a few basic concepts about the stock market can help us comprehend what is happening in the larger financial sector. Although shares of stock represent ownership of corporations, the value of those shares of stock have a very tenuous connection to the actual value of a corporation’s assets, its ability to create and sell products, and even the money in its liquid accounts. During the last few months of 2008 and the first part of 2009, we saw the stock market’s major indices lose more than half their value. Journalists and economic analysts were aghast over the vast amount of “money” that was lost. I know something about this on a personal level. I had some of my 401k funds invested in the stock market. I lost about 20 percent of the value of the 401k before I shifted everything to other types of investments. But did I really lose anything? What about everyone else? What about all those trillions of dollars of “wealth” that simply vanished into thin air during these difficult months? A lesson from not-so-distant history may help us answer these questions.
A smaller stock market crash occurred in 1987. Joel Kurtzman, in his book The Death of Money, gave the following assessment of the carnage:
If measured from the height of the full market in August 1987, investors lost a little over $1 trillion on the New York Stock Exchange in a little more than two months. That loss was equal to an eighth of the value of everything that is manmade in the United States, including all homes, factories, office buildings, roads, and improved real estate. It is a loss of such enormous magnitude that it boggles the mind. One trillion dollars could feed the entire world for two years, raise the Third World from abject poverty to the middle class. It could purchase one thousand nuclear aircraft carriers.3
In 2008, similar statements were made about the vast wealth that suddenly disappeared. But what really happened? David Korten’s response to Kurtzman’s lament is instructive:
Those who invested in the stock market did indeed lose individual buying power. Yet the homes, factories, office buildings, roads, and improved real estate to which Kurtzman refers did not change in any way. In fact, this $1 trillion could not have fed the world for even five minutes for the simple reason that people can’t eat money. They eat food, and the collapse of the stock market values did not in itself increase or decrease the world’s actual supply of food by so much as a single grain of rice. Only the price at which shares in particular companies could be bought and sold changed. There was no change in the productive capacity of any of those companies or even in the cash available in their own bank accounts.4
Consider my own 401k to illustrate what really happened. I owned a few shares of stock through an investment fund. Over time, these shares grew in value. But did I actually have more money? Well, on paper, yes. The quarterly statements I received for my 401k showed that my account was worth a certain amount, and it was expressed in U.S. dollars. But that “money” wasn’t real because it wasn’t liquid. It was merely potential money. Because someone was willing to buy those shares from me at an inflated price, my account balance ballooned. Such was the case with all investors in the stock market. But was there actually more money in the stock market? Not at all. There was only an increase in perceived value. In other words, in August 2008 did I really have any more wealth than I did ten years earlier? No (leaving aside the additional money I had earned and deposited into the 401k during those ten years). Could I buy anything with those shares of stock? No. If I had cashed them in, then I would have been able to spend the money I received from their sale on all sorts of real goods and services. But I didn’t. And when I traded those shares for some safer investments, they were worth a lot less than they had been worth a few months earlier. My account balance was at that time about 20 percent lower than it was at its peak. Other investors lost much more than I did. But did the money supply actually decrease when the stock market plunged? No. So this sort of monetary expansion is really just an illusion.
The stock market, as mentioned, is just a small segment of the financial sector. Most of the economic expansion we have seen during the past few years occurred in foreign exchange transactions, in the commodities markets, in real estate, and in the nebulous world of phantom finance that encompasses derivatives of every shape and flavor, everything from forward rate agreements to credit default swaps. To put the financial sector in some sort of useful context, consider that foreign exchange transactions alone amounted to about $5.3 trillion per day in 2013, while the world domestic product rang in at only $205 billion per day. Put another way, the total value of all final goods and services produced in the world amounts to less than 4 percent of the money that is traded every day in just the currency markets. Money did not become a commodity until 1973, but now it is the most sought-after commodity of all. And minute fluctuations in the rates of exchange between currencies yield mammoth amounts of “profit” every day. This profit is somehow extracted from the system without anything at all being produced. What allows this to happen? The accelerated flow of money. I’ll explore this phenomenon in the next post, but for today let me backtrack momentarily.

The Resource Factor
I mentioned above that the economy cannot grow if the money supply does not grow. This is true, but expanding the money supply alone does not necessarily translate into economic growth. There must also be an expansion in the total mass of products created during a given time frame. And in order to make this production possible, natural resources must enter the flow and, through the instrumentality of labor and technology, be transformed from raw materials into finished products, a process that generally involves several steps and various industries. In essence, the two-company economy of Hannah Bell can grow only if the money supply expands and if new natural resources enter the system and are transformed into widgets. With these two factors in place, the two business owners can extract a profit, and the total quantity of products for sale can increase.
If the business owners are shrewd, they will try to increase their profits by doing two things: increasing the price of the widgets and decreasing their labor costs. Increasing the price of the widgets is possible if they either improve the product or create the widespread impression that all prices must simply increase over time. Decreasing labor costs is made possible by creating a surplus of workers looking for work over jobs available. In such circumstances, desperate workers are willing to labor for less pay. A related method for decreasing labor costs is to increase productivity, either through more efficient work methods or, more commonly, through technological innovation. Productivity improvement not only enables a worker to produce more product in a given time frame, but it also allows a company to produce the same amount of product with fewer workers. In this way, productivity improvement helps create a surplus of labor, which places downward pressure on wages. The result, of course, is more profit going into the pockets of the owners and business executives. The downside is that the workforce has less disposable income with which to buy widgets. This is the Hobsonian world we have come to accept.
When an economy becomes highly productive, it requires fewer workers who actually produce the physical products people need. The result is that the surplus workers find lower-paying jobs in an expanding service sector, which creates largely superfluous products. So, what happens when we need only 10 percent of the workforce to manufacture the products we need and want? What do the rest of us do? Do we get up each morning, as Harvard business professor William Abernathy once suggested, and press each other’s pants? Or, as an economist friend of mine put it, “I’ll cut your hair, and you’ll cut my hair, and we’ll both get rich.” A nation of superfluous service workers is not an economically healthy nation and never can be. This is the dilemma of a postindustrial society.
The crux of the issue is that increased productivity, aimed at making companies competitive and profitable, is inadvertently creating a greater division between the haves and have-nots and is therefore diluting our ability to consume all that we produce. Corporate capitalism’s solution to the dilemma of a shrinking manufacturing workforce is to introduce new products—primarily services and technological gizmos—at an accelerating pace. This creates new jobs (generally at lower pay) to replace the ones we have eliminated or exported and thus curbs unemployment, though not misemployment; it also pressures us to consume more than ever before (in an expanding economy, consumption must perpetually increase) and keeps the wheels of capitalism spinning—faster and faster.
And this brings us to a good stopping point, before we tackle the idea of speed that masquerades as growth.
1. Herman E. Daly and John B. Cobb Jr., For the Common Good: Redirecting the Economy toward Community, the Environment, and a Sustainable Future (Boston: Beacon Press, [1989] 1994), 416.
2. Daly and Cobb, For the Common Good, 426.
3. Joel Kurtzman, The Death of Money (New York: Simon Schuster, 1993), 98.
4. Korten, When Corporations Rule the World (San Francisco: Berrett-Koehler; Bloomfield, Ct.: Kumarian Press, 1995), 192.

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