Helmut Schmidt, profits and the economy

Note kindly tranlated by Anne-Marie de Grazia

The death of Helmut Schmidt evokes again one of his most often, and most wrongly used declaration : « today’s profits create the investments of tomorrow and the jobs of after-tomorrow »[1]. This declaration was much cited, particularly by Valery Giscard d’Estaing, beginning in 1976, and elevated to the height of a theorem. Yet it is a purely political declaration, but one which is giving itself the appearance of economic scientificity. It has been meant to state that the share of salaries in the added value of companies was too large in comparison with the share of profits. This is indeed what was understood, and the politics applied from the end of the 1970s in various European countries, but most of all in France after 1983 and the « European turn » of François Mitterrand, have draped themselves in his supposed authority. If the share of profits has drastically increased since then, this has had no effect on investments, and even less on employment. Whence the notion, widespread on the left, that his declaration had been only political, and it has become fashionable to jeer at Helmut Schmidt. In reality, his declaration is more interesting than it looks at first sight. It describes one particular situation, the one of a dynamic vision of the economy dating back to the 1950s and 1960s. It sheds light on the consequences of the financialization of economies, a process which has started developing precisely at the beginning of the 1970s. It states the question of the origin and of the sources of investment, which remains a very relevant problem today.

 

The origins of investment at the beginning of the 1970s

A priori, there seems to be something self-evident in this declaration: in order to invest, one needs money, and in order to have money, one needs to have profits. But this implies that investment would be furnished in its totality by what is called self-financing. Except that, when Helmut Schmidt was uttering his famous declaration, this was not the case. Depending on the countries, the share of self-financing is more or less elevated. But it is always far from 100%. In fact, bank credits (with the possibility for the banks to have these refinanced through the Central Bank in the case of France and Italy) has always been one of the important sources of investment. This is what is called a debt economy [2] or, deriving from the English expression, an overdraft economy[3].

Moreover, one notices that in France, investment understood by way of the accounting category of Formation Brute de Capital Fixe or FBCF (Brute Formation of Fixed Capital) is undergoing an important increase between 1950 and 1973, the year it is culminating, whereas the share of salaries in the added value is increasing during this period. Particularly, the 5 years going from 1968 to 1973 are characterized by a very high increase of the FBCF in percentage of the GDP.

 

Chart 1

A - 1

Source : INSEE accounting

In fact, Helmut Schmidt’s declaration only applies to companies which are excluded from bank credits. There is indeed a pertinence, for these companies, in the link between profits and investments. But the impact of these companies on the totality of investments is rather weak during the 1960s and 1970s. At the moment when Helmut Schmidt is uttering his statement, it is globally wrong, except for companies which cannot have recourse to bank credit. But, if one doesn’t consider the case of one single company, but of all companies, Helmut Schmidt’s statement becomes a little bit more pertinent.

 

Do profits always end up as investments?

In fact, banks of deposit, in the 1960s and at the beginning of the 1970s, are forced to grant credits to households as well as to companies, because most of them do not have access to the financial markets. The economy in Western Europe is characterized by very strong and restrictive financial regulations. In other words, global savings deposited in the banks can only be invested in bank credits benefitting households and companies. From this point of view, profits, if they are saved, are indeed financing investment, even if it is not necessarily investment in the companies where the profits were made. But the same goes for salaries. The link between savings, whether resulting from profits or from salaries, and investment is therefore a very strong one.

However, in 1973, with the Jamaïca Agreements, a new period is dawning. The fixed – but revisable – exchange rates were progressively left over to the market at the occasion of the Jamaïca Conference in 1973. The passage to floating exchange rates induced the very brutal fluctuations which we have known since the end of the 1970s and the ever increasing speculative nature of this system, leading to the present crisis [4]. The new financial products which are then beginning to develop will become an increasing source of profits for financial operators and for banks. By putting an end to the Bretton Woods system, doors were indeed opened onto the unknown.

This development in the number and in the nature of financial titles will continue more and more, despite the present crisis. So that we are witnessing two phenomena which are narrowly linked. On the one hand, bank business tends to move away from credit activities, which imply reciprocal knowledge and relations between the bank and its customers, in order to move ever more towards « market » activities, meaning, speculative activities. On the other hand, “quasi-banks” are developing out of investment funds and hedge funds, funds specializing in speculative operations. Large companies themselves, of which we were formerly following the « multinationalisation, » are discovering, through the management of their assets, the possibility for them to realize new profits. So that a company such as General Electric is nowadays realizing more profits through its financial branch than through its own industrial activities. So that everything seems to start with finance and go back to it. Besides profits, companies gain considerable flexibility which allows them to remove a large share of their profits from the reach of the fiscal systems of their country of origin by taking advantages of the planet’s various tax havens.

Banking and financial deregulation has been implemented from the 1980s. In the United States, this movement started with the Depository Institutions Deregulation and Monetary Control Act of 1980 which started the dismantling of regulatory frameworks created in response to the crisis of 1929. It culminated in the Gramm-Leach-Bliley Act of 1999[5] which annulled the Glass-Steagall Act of 1933[6] and opened the door to mergers between banks and insurances. We must point out here that this process was largely the result of a bipartisan consensus in the United States. The first law of 1980 had been prepared during the Carter presidency (1976-1980) and the second one under the second mandate of Bill Clinton (1996-2000).

A similar process took place in Europe, with the deregulation of the City of London, soon to be imitated in France under the impulse of the then Minister of Finances, Pierre Bérégovoy, and reinforced in 1993 under the conservative government of Édouard Balladur. These practices were consolidated on the European scale by various directives and reinforced by the principles adopted within the Eurozone. From 1997 to 2007 we are witnessing a constant complexification of financial products and practices within a forthwith deregulated framework. In 2007, CDS[7] reached an equivalent of 45,500 billion dollars, with a nine to one increase over the latter three years [8]. The explosion of instruments derived from credit has been spectacular [9]. From a practically non-existing level in 1998, their level reached 1,500 billion in 2002, 8,500 billion in 2004, 17,000 billion in 2005 and 34,500 billion in 2006. They were to reach 46,000 billion in 2007. The complexification of the processes of « structured finances » has moreover cast a veil of opacity over the circulation of debt claims[10].

This entailed a very important increase of the share of financial profits in total profits. The latter made up between 10 and 15 % of profits in total profits during the 1950s. They are now reaching between 35 à 40 %. But this mechanism also implies that an increasing share of savings is being deviated from investment activities and used more and more for speculative activities. Helmut Schmidt’s declaration then reveals itself, in the post-1973 world, to be a dangerous delusion. The increasing complexification of new financial instruments has brought an ever increasing opacity of transactions, without one being able to demonstrate that this has had a positive impact on investment and on the development of non-financial companies [11].

 

The engines of investment

So that the current financialistion of the economy tends to turn savings away from investment. But this raises another question. Is investment linked to the variations in profit, or to the rate of profit, or is it subjected to the incertitude concerning demand?

The question of investment, and the study of investment functions, has been mobilizing the attention of economists for many years [12]. The recurrent problem is that this question is generally tackled within a probabilist framework [13]. One supposes the manager (whether he is an individual, or a « representative » manager, or an aggregate at the level of the economy) to be in a position to provide probabilities concerning the profits of a future investment. But this does not take into account the question of radical incertitude[14]. However, this question is of capital importance, particularly in the present period. The question of radical incertitude and of its impact on investment was studied by Edmond Malinvaud in the 1980s[15].

Empirical studies [16] were not able to account for any negative link between investment and the cost of the use of capital, nor even between investment and real interest rate. Indeed, current profit gives no information on the perspectives of future profits, which alone are apt to incite companies to invest.

Moreover, the question of the partial, or total, irreversibility of investment is then coming up [17]. Since the article by Pyndick, it has undergone a certain number of transformations[18]. For instance : « Investment not only implies acquiring capital on the market, but also the transformation of this «indeterminate » capital into a specific capital, in keeping with the usage of any given company. It is precisely this second cost of a specification of the capital which produces the effect of irreversibility in the decision to invest, that is, which renders it more costly to do, then to undo, than to do nothing. So that the irreversibility of the decision to invest must be understood in the same way as irreversibility is meant by the physicist : a physical system which has undergone a transformation can return to its initial state only at the cost of an expense of energy superior to the one which had at first operated the transformation[19]». The models of choices which are irreversible in incertitude [20] are, moreover, compatible with the fact, which has been empirically observed in several countries, that companies go through periods without any investments. So that an empirical study about the American economy lead by Doms and Dunnes[21] shows, at the scale of companies, that years without investments follow upon years when investments are, in the contrary, very important. A similar result was found for France; Duhautois and Jamet[22] have shown that this succession of periods with and without investments can also be verified in the case of French companies. Moreover, one must take into account the fact that global accumulation implies an accumulation of highly specific assets [23], assets which are the most vulnerable in case of an unexpected reversal in the economic context. In fact, only the adoption of the ex ante/ex post approach allows for the integration of radical incertitude [24].

Finally, one must take into account the synergy between private investments and public infrastructure investment, whose effect is important [25]. This effect is the stronger if these investments are being made on infrastructures of transportation (roads, railroads, harbors and airport platforms) but also on those infrastructures enabling the collective consumption of the population (water and waste, public health, etc…)[26]. Recent studies have put in evidence an effect of an agglomeration economy [27]. An estimate of such effects of agglomeration has even been made in the French case [28]. This is sending us back to the very controversial fiscal multiplier. This « multiplier » has been the subject of so much theoretical work, essentially in line with Keynes’ publication of the General Theory… in 1936, as well as important empirical work [29]. If its value is high, between 1.5 and 2.5 as indicated by recent research[30], one can deduce that private investments will be affected positively by public spending. In fact, it seems indeed that the value of the fiscal (public spending) multiplier varies widely depending on the economy being far, or in the contrary, being close to its technical frontier of full employment [31].

 

As we can see, the statement pronounced in 1974 by Helmut Schmidt has but scant relation with reality. But in the same time, it illuminates the extremely complex links existing between investment, profits, demand and consumption. And, from this point of view, one can see that even a declaration which is wrong can help progress in the knowledge of the most important economic mechanisms.

 

Notes

[1] In a speech delivered on November 3, 1974, a few weeks after succeeding Willy Brandt as Chancellor of the GFR.

[2] F. Renversez, “De l’économie d’endettement à l’économie de marches financiers” in Regards Croisés sur l’économie, 2008/1, n°3, pp. 54-65

[3] Goux J.F., « Les fondements de l’économie de découvert. A propos de la théorie de la liquidité de Hicks » in Revue Economique, 1990, Volume 41, n°4, pp. 669-686.

[4] Maurice Allais has identified floating exchange rates as a risk factor inducing, by protection, the development of new financial products, which lead themselves to a new dissemination of risk, all the way to systemic risk. See Allais M., La Crise mondiale d’aujourd’hui, Clément Juglar, 1999.

[5] Available on the site of the Federal Trade Commission (www.ftc.gov/privacy/privacyiitiatives/financial_rules.html ).

[6] The Glass-Steagall Act, which was voted on June 16, 1933, organized the American banking system in distinguishing carefully between « credit » activities and « market » activities, in reaction to the financial turmoils which had provoked the crisis of 1929.

[7] Or credit default swap (CDS). A CDS is an agreement between two parties in order to exchange a risk against an income. The buyer of a CDS pays a regular premium (annually or monthly) in exchange for a guarantee on a credit risk of a given amount.

[8] See J. P. Morgan Corporate Quantitative Research, Credit Derivatives Handbook, New York, J. P. Morgan, December 2006, p. 6.

[9] See J. P. Morgan Corporate Quantitative Research, Credit Derivative: A Primer, New York, J. P. Morgan, January 2005.

[10] See A. B. Ashcraft, T. Schuermann, « Understanding the Securitization of Subprime Mortgage Credit », FIC Working Paper, vol. 43, n° 07, Wharton Financial Institutions Center, Philadelphia (Pa.), 2007.

[11] The IMF indicates thus: « [] some complex products have brought little to the financial system. Moreover, they have probably aggravated the depth and length of the crisis » Containing Systemic Risks and Restoring Financial Soundness. Global Financial Stability Report, Washington (D. C.), FMI, April 2008, p. 54.

[12] See the special issue of the review Économie et Statistique, N°341-342 entirely dedicated to this question, and particularly the introduction realized by Épaulard, A., « À la recherche des déterminants de l’investissement des entreprises », in Économie et Statistique, N°341-342, 2001, pp. 3-14. A slightly older text establishes a good assessment of the new theories of investment ; see : Bourdieu J, Benoît Cœuré and Béatrice Sédillot « Investissement, incertitude et irréversibilité », Revue économique, Volume 48, n°1, 1997. pp. 23-53

[13] Jorgenson D.W. (1963), «Capital Theory and Investment Behavior», American Economic Review, vol. 53, n°2, May, pp.247-259.

[14] Malinvaud, E, « Profitability and investment facing uncertain demand », Document de travail de l’INSEE, n° 8303, Paris, 1983

[15] Malinvaud, E., « Capital productif, incertitudes et profitabilités », Document de recherche de l’IME, University of Dijon, n°93, 1986.

[16] Blanchard O., « Investment, Output, and the Cost of Capital: a Comment », Brookings Papers on Economic Activity, 1, 1986, pp. 153-158.

[17] Pindyck R.,«Irreversible Investment, Capacity Choice and the Value of the Firm», American Economic Review, vol. 78, n°5, 1988, December, pp. 969-985.

[18] Bourdieu J, Benoît Cœuré and Béatrice Sédillot « Investissement, incertitude et irréversibilité », Revue économique, op.cit.. Abel A. and Eberly J., « A unified model of investment under uncertainty », in American Economic Review, vol. 84, 1994, n°6, pp. 1369-1384.

[19] Bourdieu J, Benoît Cœuré and Béatrice Sédillot « Investissement, incertitude et irréversibilité », Revue économique, op.cit., p. 26.

[20] Abel A. and Eberly J., « The Effect of Uncertainty and Irreversibility on Capital Accumulation », NBER Working Paper, n° 5363, NBER, Cambridge, Mass., 1994.

[21] Doms M. and Dunne T., «Capital Adjustment Patterns in Manufacturing Plants», Review of Economics Dynamics, vol. 1, n°2, April 1998, pp. 409-429.

[22] Duhautois R. and Jamet S., «Hétérogénéité des comportements d’investissement et fluctuations de l’investissement», Économie et Prévision, 2002, n° 149, pp. 103-115.

[23] Riordan, M.; Williamson, O., « Asset Specificity and Economic Organization », International Journal of Industrial Organization, vol. 3, pp. 365-378, 1985. Choate, G., Maser, S., « The Impact of Asset Specificity on Single-Period Contracting », Journal of Economic Behavior and Organization, Vol 18, pp. 373-389, 1992.

[24] We are using this term in its Post-Keynesian meaning. Se, H.P. Minsky, « The essential characteristics of Post-Keynesian Economics », The Levy Institute, working paper, Septembre 1993. See also, Arestis, P., Ana Rosa González and Óscar Dejuán, « Investment, Financial Markets, and Uncertainty », The Levy Economics Institute, Working Paper n° 743, Decembre 2012.

[25] One may consult on this subject D.A. Aschauer, “Is public expenditure productive?”, in Journal of Monetary Economics, vol. XXIII, n°2, March, 1989, pp. 177-200. Idem, “Why is Infrastructure Important?”, in A. H. Munnell, (ed.), Is there a Shortfall in Public Capital Investment, Federal Reserve Bank of Boston, Boston ; and R. Ford & P. Poret, “Infrastructure and Private-Sector productivity”, OECD, Departemnt of economics and statistics, Working paper n°91, OECD, Paris, 1991.

[26] Hall, Robert E. 2009. “By How Much Does GDP Rise If the Government Buys More Output?” Brookings Papers on Economic Activity 40 (2), pp. 183–231.

[27] Henderson J.V., « Marshall’s Scale Economies », Journal of Urban Economics, vol. 53, 2003, n° 1, pp. 1-28. Rosenthal S.S. and Strange W.C., « Evidence on the Nature and the Sources of Agglomeration Economies », in Handbook of Urban and Regional Economics, J.V. Henderson and J.-F. Thisse (éds.), vol. 4, Cities and Geography, chap. 49, pp. 2119-2171, North-Holland, Amsterdam, 2004.

[28] Y. Barbesol and A. Briant, « Économies d’agglomération et productivité des entreprises : estimation sur données individuelles françaises », in Économie et Statistique, n° 419-420, August 2009, pp. 31-54.

[29] T Baunsgaard, A. Mineshima, M. Poplawski-Ribeiro, and A. Weber, “Fiscal Multipliers”, in Post-crisis Fiscal Policy, ed. by C. Cottarelli, P. Gerson, and A. Senhadji, Washington: International Monetary Fund, Washington DC, 2012. Spilimbergo, A., Symansky, S., and M. Schindler, 2009, “Fiscal Multipliers,” IMF Staff Position Note, SPN/09/11, May 2009, FMI, Washingtonxl DC..

[30] Blanchard O., et D. Leigh, « Growth Forecast Errors and Fiscal Multipliers », IMF Working Paper, WP/13/1, FMI, Washington D.C., 2013.

[31] Christiano L., M. Eichenbaum, and S. Rebelo, « When Is the Government Spending Multiplier Large? », Journal of Political Economy, Vol. 119, No. 1 (February 2011), pp. 78-121.

 


Jacques Sapir

Ses travaux de chercheur se sont orientés dans trois dimensions, l’étude de l’économie russe et de la transition, l’analyse des crises financières et des recherches théoriques sur les institutions économiques et les interactions entre les comportements individuels. Il a poursuivi ses recherches à partir de 2000 sur les interactions entre les régimes de change, la structuration des systèmes financiers et les instabilités macroéconomiques. Depuis 2007 il s’est impliqué dans l’analyse de la crise financière actuelle, et en particulier dans la crise de la zone Euro.

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