Fiscal Policy and the Rate of Profit

For Marx, the most important tendency of a capitalist economy is the ‘law of the tendential fall in the rate of profit’ (LTFRP). This ‘law’ is often misinterpreted as referring to a permanent fall in the rate of profit, but it actually refers to a tendency that is overcome periodically through crises. Marx argued that during an expansionary phase, there is a tendency for the rate of profit to fall until a crisis point is reached, after which capital values collapse, cheapening prospective investments. This revives profitability and paves the way for a new expansionary phase. Crises, while causing widespread hardship – including bankruptcies, mass unemployment and poverty – play a functional role under capitalism of restoring profitability for those capitalists, now fewer in number, who survive the process.

Marx’s tendency emerges out of the internal logic of capital. But in a fiat-money system, capital itself operates within a broader institutional framework shaped by society itself, especially through representative government. Whereas the logic of capital is determining under a commodity-money or commodity-backed money system, ultimately rendering government and the general community subservient to its imperatives, this need not be the case in a fiat-money system.

As a matter of national accounting, fiscal policy has a direct relationship with realized aggregate profit. Moreover, since the average rate of profit can be expressed as the ratio of aggregate profit to the amount of money capital tied up in production, it follows that fiscal policy is also directly related to the average realized rate of profit. This suggests that Marx’s tendency can be attenuated, up to full utilization of capacity, through appropriate use of fiscal policy. (See Thinking in a Macro Way.)

Fiscal policy also influences the level of private saving. In a closed economy, the budget deficit translates into net private saving, dollar for dollar. Considering the private sector as a whole is currently deep in debt, fiscal policy has an important role to play in restoring private-sector balance sheets.

The purpose of this post is to trace the connections between fiscal policy, the rate of profit and net private saving in a little more detail, and to draw out the basic policy implications.

1. Marx’s Tendency for the Rate of Profit to Fall

If, for simplicity, we abstract from fixed capital, then the average value rate of profit, r, in Marx’s theory is:

r = s/(c + v)

c is constant capital (value transferred from plant, machinery, raw materials)
v is variable capital (value advanced for the employment of workers)
s is surplus value (value created by workers in excess of v)

Value can be expressed in amounts of socially necessary labor time or equivalent monetary amounts. The formula says that the average rate of profit is equal to surplus value (s) divided by the value productively invested by capitalists (c + v). For instance, if capitalists invest $80 in c and $20 in v, resulting in the production of $120 in value and surplus value of $20, the rate of profit is 20/100 = 20%.

For Marx, c (plant, machines, raw materials) represents value produced in a previous production period. In aggregate, these elements of capital only pass on their previously existing value to the total value (and total price) of the new output. In contrast, labor worked in the current period generates new value. In the example provided above, labor added $40 in value during the production period. Labor was paid $20 (i.e. v), which left a surplus (s) for the capitalists of $20.

To avoid confusion, it is important to understand that Marx’s argument applies to value, not physical output or wealth. He is not suggesting that labor is the only source of physical output or wealth. Nature, other animals and machines all create new physical output and wealth, as does labor. The argument, rather, is that only labor translates into new value. Plant, machinery and raw materials used up in the production period only pass on their preexisting value (actually, their prices). Nature, on the other hand, does not transfer any value to output. Instead, private property rights give owners of natural resources a legal entitlement to a payment of rent, which comes out of the surplus value created in the production period.

The rate of profit can be rewritten:

r = (s/v)/(c/v + 1)

In this formula, s/v and c/v have special meanings for Marx.

The ratio s/v is the ‘rate of surplus value’ or ‘rate of exploitation’. If workers produce $200 of new value and are paid $100, the rate of surplus value is 100%. It means half the working hours were necessary to pay labor, and so were not appropriated by capitalists as surplus value.

The ratio c/v is the ‘organic composition of capital’.

The formula shows that as c/v rises (due to technical progress that tends to shed labor per investment dollar over the expansionary phase), the rate of profit, r, falls, holding other factors constant. Capitalists can partially offset this tendency by wringing more value out of labor per dollar invested in variable capital. That is, they can try to increase the rate of surplus value, s/v. They can do this by increasing s through technical innovation (an increase in relative surplus value) and enforcing more intensive work and a longer working day (an increase in absolute surplus value) as well as through reductions in v (by restricting employment and wage growth). However, Marx argued that these countervailing tendencies cannot offset the rise in the organic composition of capital indefinitely. First, increases in absolute surplus value are limited by the number of working hours in the production cycle; e.g. a day only contains 24 hours, placing an absolute limit on the working day. Second, increases in relative surplus value are mainly achieved through greater investment in c, and so raise the organic composition of capital, c/v, at the same time as s/v. Third, restricting wage and employment growth, which restricts the growth in v, not only raises s/v, but also c/v.

So during an expansionary phase, Marx argues that c/v rises and r falls over time. Capitalists offset this tendency as much as possible through attempts to increase s/v, but these efforts can’t fully compensate for the rise in c/v. The solution within capitalism is for a crisis to bring about a collapse in capital values (and prices). This dramatically reduces c, and hence c/v, and causes a dramatic rise in the rate of profit, r. The system is then ready for a new expansionary phase.

Marx’s argument that the countervailing factors cannot offset the tendency for the rate of profit to fall is amenable to empirical testing. In what I consider to be an important new study, Andrew Kliman argues that the rate of profit in the US has behaved in the way Marx theorized over the post-war period. (The study can be obtained here.) On the basis of his empirical analysis, Kliman argues that the failure of the rate of profit to revive sufficiently after successive post-war crises (due to insufficient capital destruction) has been the underlying reason for the unsustainability of successive recoveries from crises, especially since the 1970s, consistent with Marx’s theory.

From Kliman’s perspective, governments have been intent on preventing massive destruction of capital at the onset of each post-war crisis. The reason for this is simple. Although the destruction of capital results in a dramatic rise in profitability, it is devastating both for weak capitals and for the general population. In the face of such a social upheaval, the legitimacy of capitalism itself comes into question, and the risk (to capitalists) of social revolution rises.

2. Private Debt and the Private-Sector Desire to Net Save

Marx’s theory, and Kliman’s study, suggest that the increasing tendency toward speculative rather than productive investment is due to the drying up of profitable productive investments. The result has been relatively weak growth in GDP (compared with the immediate post-war period) and a consequent recourse to more and more speculation as financial capital seeks higher returns, creating a level of private debt that is unsustainable in relation to real-value creation (or GDP growth). Attempts to prop up the rate of profit through attacks on real wages and living conditions have at the same time resulted in a marked increase in inequality, providing further impetus toward private debt.

The economy has reached a point where many private firms and households need to spend less than their incomes in order to pay back debt. For this to be possible, the government must enable the private sector’s efforts to maintain a financial surplus in which disposable income (income minus taxes) exceeds private spending (the sum of private consumption and private investment). That is the lesson of one of the accounting identities that modern monetary theory (MMT) stresses. For a closed economy:

Government Deficit = Private Sector Surplus

In a closed economy, the private sector can only increase its financial surplus if the government increases its deficit.

For an open economy:

Government Deficit = Non-government Surplus

=> Government Deficit = Domestic Private Sector Surplus – Net Exports

In an open economy with a trade deficit (like the US), a government deficit is even more necessary if the domestic private sector wishes to maintain a financial surplus.

The worst thing the US government could do right now is to try to reduce its deficit. Not only is it likely to fail in its immediate objective (by negatively impacting demand, output, income and tax revenues) but it will also defeat the private-sector attempt to save and pay off debt. If firms attempt to save to pay off debt, and households attempt to save to pay off debt, there are only two remaining avenues for maintaining the level of aggregate demand: government spending and exports. Deficit expenditure, if it happens to weaken the dollar, will somewhat help exports. But the impact of improved exports is likely to be small compared to the impact of sustained and large deficit expenditures (because other countries may also try to prop up their exports through competitive devaluations, protectionism, etc). Expansionary deficit spending is the only policy that can enable the private sector to pay off its debt. Of course, an alternative is for the private debt to be written off. It is likely that such an action would meet with stiff resistance from powerful sections of the capitalist class, to say the least, but that does not mean it is impossible.

The main political obstacle to sustained, highly expansionary government expenditure is an unfounded fear of public debt. The fear is unfounded in countries where the government is the monopoly issuer of its own fiat currency. Currency-issuing governments face no revenue constraint. There is a real resource constraint. There are also political constraints. But there is no financial constraint. There is no logical need to issue public debt at all merely to finance government expenditure. The reasons public debt is in fact issued, in practice, are: (i) as a method of interest-rate targeting (but this could be achieved in other ways); (ii) as an ideologically motivated attempt to restrict the role of government (though an ineffectual one, given institutional realities and the capacity of the currency issuer to spend on its own terms); and (iii) as a propaganda mechanism to imply government faces a “budget constraint” similar to a private household (which creates a misguided fear of public debt and gives the impression social needs are not being met because of legitimate affordability issues, even when large reserves of labor power and other resources are clearly available).

Relating back to Marx’s profit-rate tendency, sustained deficit expenditure not only provides a means to address the private-debt problem but also helps to prop up the economy-wide average rate of profit whenever output is below full capacity. At the aggregate level, Marx maintained that total profit equals total surplus value, total price equals total value, and the average rate of profit equals the average rate of surplus value. If it is assumed, for simplicity, that all surplus value is realized in exchange, the impact of fiscal policy on profitability can be considered in price rather than value terms on the basis of Kalecki’s profit equation:

P = CP + I + GD + NX – SW

In this identity, P is aggregate profit, CP is capitalist consumption, I is private gross investment, GD is the government’s deficit, NX is net exports and SW is worker saving. The profit identity shows that aggregate profit is the sum of capitalist expenditures (CP + I), the government deficit (GD) and net exports (NX) minus worker saving (SW). Clearly, the government deficit adds to aggregate profit except to the extent that some of the proceeds of government net expenditure are saved by workers or leak to imports. For the global economy as a whole, net exports sum to zero. If, following Marx and Kalecki, workers in aggregate are assumed not to save, the sum of national government deficits adds to aggregate global profit. The reason for this is that government expenditure, whether it initially goes to workers or capitalists, ultimately ends up in the hands of capitalists, since workers, in aggregate, spend the wages they earn on consumption items.

For a national economy, the average rate of profit, r, in price terms can be expressed:

r = P/K = (CP + I + GD + NX – SW)/K

where K is the dollar amount of fixed capital investment tied up in production. Since, under conditions of unemployment and excess capacity, the government’s deficit will add to the numerator of the profit expression without adding to the costs of fixed capital investment K in the denominator, the government’s deficit boosts the average rate of profit and improves investment prospects for the private sector. If, in contrast, the government imposes cutbacks and austerity, this squeezes the private sector, impacting negatively both on the domestic private sector’s financial surplus and the average rate of profit.

Note, though, that the impact of government deficits on the rate of profit, operating through the demand channel, reaches its limit at full capacity. At that point, it is no longer possible to raise P relative to K simply through government net expenditure. If, as Marx’s theory suggests, there is a tendency for K to increase over time relative to the level of P realizable at full capacity, a tendency for the rate of profit to fall will ultimately assert itself. This will have profound implications for capitalism and any attempt, via policy, to maintain it as an economic system. Marx’s view that the profit-rate tendency is the most important ‘law’ in political economy can be understood in this light.


18 thoughts on “Fiscal Policy and the Rate of Profit

  1. Thanks, Tschaff. I am enjoying checking out your blog also. Good stuff.
    Addendum: I’ve put up an “About” page now.

  2. I am having trouble with your last equation. In my understanding capital is K at the start of the accounting period but becomes K + I at the end of it (if we want to be absolutely correct it becomes K + I – Inventories). Obviously that fact makes things even worse.

    Am i missing anything?

  3. Hi Kostas. Good to see you here.

    Let me say first that your understanding is sound in that the change in K over the period will be equal to I – δ, where I is gross investment, δ is depreciation and I – δ is net investment. So, yes, if we want a measure of K at two particular points, K(t+1) = K(t) + I – δ.

    However, in the present context, the choice of K is meant to represent the amount of fixed capital investment that happened to be tied up in production over the period. This is because we want to have some measure of profit as a percentage of the accumulated fixed capital investment. The difficulty is that this accumulated fixed capital investment is the result of investment from prior periods still tied up in production in addition to any investment that occurs in the current accounting period.

    This is obviously a bit tricky to measure exactly, and it is not clear what measure we should use for the purpose. For example, we could take some average K over the period, or its end value, or its start value, or some other measure.

    This creates a technical difficulty, but doesn’t alter the basic insight. Irrespective of the measure we use for K, the effect of investment will be to add both to P and K, and so tend to reduce the rate of profit. Depreciation will dampen this effect in that it reduces the size of K (since K depends on net investment) but not profit (which depends on gross investment).

    If you haven’t already, you might like to read Thinking in a Macro Way. It discusses the effects of investment on the rate of profit in a little more depth, although it still doesn’t shed any light on the appropriate measure of K in the formula.

  4. PeterC,

    I am very impressed and almost shocked by this analysis.

    I’ll be honest: I don’t want you to believe I am claiming priority over this. Not at all. You have full priority.

    I am yet to commit my own thoughts to paper. And this article was written long before I conceived my own ideas.

    But, yes, on my own, I have arrived at much of what you said here.

    I am sure you must have checked back at “Capital Vol. III Part III. The Law of the Tendency of the Rate of Profit to Fall. Chapter 14. Counteracting Influences”.

    Unlike many Marxists seem to believe, it is possible for the rate of profit to fall, while the exploitation rate increases: the organic composition of capital needs to increase faster than the exploitation rate. You can see this from r = (s/v)/(c/v + 1).

    Marx himself wrote in his particular style about this. The effect of an increase in the exploitation rate is not clear cut: at times, it can depress the profit rate; at other times, it can help increase it.

    This makes the settlement of the particular effect in a country and epoch an eminently empirical matter.

    And if you check Richard Wolff’s “The Keynesian Revival: a Marxian Critique” (October 23, 2010) you’ll see empirical evidence that the exploitation rate in the US has increased at least in manufacturing, and has been increasing for a long time.

    I know this may not be much in the way of empirical confirmation. But given the dearth of statistical information useful for Marxists, I’d say it is meaningful.

    Marx also speaks of other counteracting forces: depression of wages below the value of labour-power, cheapening of elements of constant capital, relative over-population, foreign trade, and the increase of stock capital. All of these forces are currently at play.

    This goes to justify my previous assertion (under Taking demand seriously) that both schools are not necessarily mutually exclusive.

    The only point where I have doubts is here:

    “At the aggregate level, Marx maintained that total profit equals total surplus value, total price equals total value, and the average rate of profit equals the average rate of surplus value. It is therefore permissible to consider the effect of deficit expenditure in price rather than value terms, following Kalecki”.

    I am not sure this is so straightforward. Because of this, that’s what I was presently investigating.

    I am very interested in your views on this last question, anyway.

  5. Magpie, I think you are correct that the connection between surplus value and Kalecki’s profit equation is not so straightforward. The point needs to be clarified. I should have written, “If we assume that the surplus value created in production is fully realized in exchange, it is permissible to discuss it in terms of the Kalecki equation”.

    We know that, according to Marx, surplus value is created in production prior to exchange and that a certain amount is created over a period irrespective of whether it is realized. If it is not realized, it will remain in physical form as a build up of inventories (and probably result in a reduction in production, investment and surplus-value creation in the ensuing period).

    By the way, don’t worry about stepping on my toes concerning priority. It is heartening to know that we are thinking along similar lines. I am interested in the compatibility (I think) of Marx with important aspects of MMT and Post Keynesian approaches more generally.

  6. Hey Pete,

    “I should have written, ‘If we assume that the surplus value created in production is fully realized in exchange, it is permissible to discuss it in terms of the Kalecki equation’.
    “If it is not realized, it will remain in physical form as a build up of inventories (and probably result in a reduction in production, investment and surplus-value creation in the ensuing period).”

    Yes, I totally agree with this.

    I’d also add that in that case the market does not clear: there is a glut of commodiities that are not sold: production/supply exceeds consumption/demand.

    I was just discussing this subject with someone else these days (I believe that this is what motivated Ramanan to write his post on Kalecki, although I don’t quite figure what he is saying in the post).

    The discussion I was having was related to the Jerome Levy Institute paper that Ramanan linked to, specifically to its Fig. 2 (circular flow diagram, considering a capitalist economy, depicting only monetary flows; and no leakages, no government, no foreign sector).

    I was arguing, like you explained above, that in that scenario, the business sector (i.e. the capitalists) may not be getting any profit (surplus value realized, that is) but this does not mean they don’t keep a surplus output (i.e. commodities). If they didn’t, then to all purposes there are no capitalists in that economy, which is absurd.

    Nowadays, if you check any popular macro textbook, you’ll be hard pressed to find any reference whatsoever to circular flows, let alone the diagram itself.

    The Jerome Levy paper does go into detail about this, but only considering monetary flows.

    In contrast, in older macro textbooks one could find a similar circular flow diagram, but including also physical flows of commodities (goods and services) and means of production and labour. In other words, it contained two parallel circuits: money and physical flows.

    This was useful, because it reminded readers that it is not just a matter of monetary flows.

    But this is not the whole thing I was referring to in my previous post: I think one needs to go to the relationship between a firm’s individual balance sheet/statement of income and expenses and GDP considered as an aggregate of individual balance sheets and i/e statements.

  7. Magpie,

    What I was trying to say was that investment and deficits both lead to profits at the macro level.

    This is by first looking at in an abstract accounting sense and then later using the Levy article show how this actually happens.

    Imagine a telephone company which purchases equipment by issuing securities such as stock market shares. It is earning revenue through receipts and has current costs such as wages and interest payments. The purchase of the cellular towers does not affect the profits but for the firm selling it, it brings revenues and hence profits. This firm of course also has costs such as wages and interest payments. Both are profitable – and pay dividends and have retained earning and also households save. It is crucial to understand that I appears with a plus sign and not with a negative sign (except depreciation of existing stock).

    Btw I actually linked Figure 4.

  8. “What I was trying to say was that investment and deficits both lead to profits at the macro level.”

    I know that, Ramanan. It may be true and all, but it does not appear relevant to the issue I am considering. Hence, my confusion.

    I am trying to understand Kalecki as a Marxist economist. Marx says that capitalists hire workers because of the workers’ labour power.

    As a commodity (btw, this is how commodity is to be understood: something produced for sale in the market, not for consumption by its own maker), labour power has a unique property: it creates more value than what it receives as pay. In other words: bosses don’t pay us because we’re pretty or because they are nice. They pay us because we earn money for them, in excess of our pay. In this, human labour is different from any other commodity used as input.

    So, how come when there is no government (note that this automatically rules out Fig. 4, that you linked), there is no profit? Aren’t there supposed to be capitalists and workers in a capitalist economy without government?

    One answer is to say (as a dimwitted progressive I know did): “Ah ha! Gotcha, Karl Marx! The old German guy is a metaphysicist” (meaning not metaphysicist in a philosophical sense, which is bad enough; no, what this bloke really meant is that the guy was bananas).

    Another more accurate answer is to say that there is a surplus output, which was not transformed into money profit: it was not realized. It was not sold, it became unintended inventories.

    But this is not just semantics. Or a pathetic attempt to cover some old German guy’s ass: it’s important for economic theory. It’s important because that’s the very same reasoning explaining the possibility of general gluts.

    The difference between the two answers lies in understanding that there is a flow of payments and revenues and a corresponding flow of commodities (not just a flow of payments and revenues).

    Note that to assume that all output was sold, is what Say’s Law does: when that happens one says that the market cleared.

    To say that there was a surplus output that was not realized and that, therefore, no profit was made, is equivalent to state that Say’s Law failed: the market did not clear.

    But there is another point in this discussion, beyond its theoretical interest. The topic is also deliciously ironic, because the very same progressive that jump to the opportunity of crying “metaphysics”, also claims to accept Keynes’ and Kalecki’s ideas, who, as it so happens, were the first modern economists to believe in general gluts.

    The irony doesn’t stop there, however. The fundamentalist libertarians who believe in the profit motivation also want to reduce government (if not to eliminate it outright).

  9. Magpie,

    “So, how come when there is no government (note that this automatically rules out Fig. 4, that you linked), there is no profit? Aren’t there supposed to be capitalists and workers in a capitalist economy without government?”

    I think the logic of Figure 4 applies even in case of no government.

    So are your points really related to the “paradox of profits”? In my opinion there is no paradox.

  10. “I think the logic of Figure 4 applies even in case of no government.”

    Perhaps you think it applies, but I believe it doesn’t. And since I am trying to explain Fig. 2 to myself, I’d say in this what’s clear to me is what counts.

    Let’s try with an example: let’s assume Joe is asking Bob a question about particle collisions involving perfectly inelastic particles. Something like: “what happens when two perfectly inelastic particles collide?”

    If Bob said that “it happens exactly the same as when two not perfectly elastic particles collide” would be of little use.


    Because the case of not perfectly elastic particles is more complex. It’s really unusual to try to explain a simpler case using a more complex one: the procedure is to try to explain a more complex case using a simpler one.

    Incidentally, in the case of Bob and Joe, it would be mistaken, too: collisions between inelastic particles (they usually bounce) are different than collisions between not perfectly elastic particles, as anyone who has seen a car crash can bear witness.

    “So are your points really related to the “paradox of profits”? In my opinion there is no paradox.”

    I have no idea what you are talking about. I’ve never heard of a “paradox of profit”.

    But going back to Fig. 2. The way I understand it, there is no paradox either. Capitalists do what capitalists are meant to do: they get a surplus output and pay their workers enough to reproduce their labour power (with that pay, workers buy a part of the output). Capitalists fail to get a profit because they cannot sell the whole output (they keep Output – Part of output bought by workers). But they still keep an inventory. Everybody is happy: Kalecki is right, so is Marx.

    It’s when one insists that capitalists sell the whole output (which I could not find assumed in the paper, btw) that paradoxes arise: if capitalists sell the whole output, where is the profit? Not in Fig. 2, to be sure: it clearly says Profit = $0.

    So, there is no profit (I repeat, as stated in the paper itself) and capitalists get nothing, not even unsold inventories?

    Tell me honestly: does this sound even remotely plausible to you?

  11. Magpie,

    I guess I understand what you were trying to say.

    You are saying the assumption that the authors implicitly assume change in inventories = 0. Which is not the best assumption!

    Hadn’t read Figure 2 carefully.

    The authors are wrong when they say “If the only source of consumer purchasing power were business sector wages, business could never
    make a profit, even if consumers spent every cent they earned.” because change in inventories are a part of profit.

    I am distinguishing inventories and capital goods.

    Is that what you were looking for?

    Are we in agreement? i.e., have I correctly figured out crucial point?

  12. Ramanan,

    Sorry for the delay in replying.

    For some reason the previous comment didn’t appear! The blog software said that the comment would be moderated (?), which surprised me a bit. And it never appeared.

    Oh, well.

    Yes, that’s more or less the idea.

    Profit comes from surplus output (i.e. the excess of actual output over inputs). If that excess cannot be sold (that is, if it goes into inventories), then no profit is realized.

    In that case, capitalists merely manage to cover their costs (wages, which go to buy part of the output; and raw material and other forms of capital).

  13. Magpie: Sorry about that. I’m not sure what happened. Comments should go through automatically other than the very first time a person contributes. An exception is that if there are multiple links in the comment, the software sometimes seems to wait for my approval. But that does not explain why your latest comment got caught in the spam filter. It’s possible I accidentally deleted your previous comment if it was held back for moderation, but usually I will see the valid comments and approve them before deleting all the spam. If I made that mistake, it might explain why the software then held back this latest comment. Anyway, apologies. Your contributions, of course, are always very welcome and greatly appreciated.

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