The Kalecki Equation: a Brief Follow-up

I am seeing a lot of analysts and advisors using the Kalecki profits equation with increasing frequency.  And with this increasing frequency of use I am also seeing increasingly misleading assumptions built into the analysis.  For instance, this article at Advisor Perspectives says profits are likely to decline because the budget deficit is declining.  This same article could have been written one year ago and would have misled investors into a disastrously bearish positioning.  The thing is, when analyzing the Kalecki equation we have to dive deep into the components to get the full picture.  If you’re not familiar with the Kalecki equation you might want to review this post of mine and then come back.

If we look at the breakdown of components as a % of GDP we get the picture below.  Now, I like to break down the corporate sector as dividends PLUS net investment because dividends have become a huge piece of the pie here in recent decades as cash flush corporations have increased dividends.  This shows the breakdown between the various sectors.  Remember, you have to use a 4 or more sector analysis here or you’ll get this all wrong.  And I have a feeling that’s what  a lot of people have been doing by looking at the government deficit and just assuming that the private sector won’t be able to generate profits without the government.  That’s the wrong way to understand this.  You have to look at the 3 sector analysis and THEN dive into the private sector through a 4 sector analysis that breaks down the business sector and households sector because businesses and net investment are just about always the key component in the profit picture.  This is all an extension off Monetary Realism’s work on S=I+(S-I).  If you didn’t understand that equation in 2012 you likely got way too bearish about the economy and the stock market which has turned out to be a very bad call.

Anyhow, when you break it down it looks like this:



In percentage form, as of the most recent quarter, that’s:

  • Government deficit: 5.1%
  • Businesses: 9.8%
  • Foreign: -2.5%
  • Personal saving: -3.3%

What should really jump out here is how the profit story has been increasingly driven by corporate America just like it normally is.  As the red bar has come down the blue bar has come up.  That’s largely because tax receipts have increased as domestic investment and dividends have gone up.  So the budget deficit has declined as a result.

What’s interesting to note here is that the budget deficit helped bolster profits in the 2009-2011 period during the Balance Sheet Recession when private investment collapsed.  Back in 2009 the tables were flipped and the government deficit was contributing twice as much to profits as corporate America was.  But that’s all reversed entirely today and now the main driver of profits is once again businesses.  Since 2011 the deficit has fallen over 30%.

Now, this doesn’t mean the budget deficit’s decline is a good thing (I actually don’t think it is because I think profits would be higher if the deficit was larger), but we’ve seen the deficit decline by -30% in 2013 and yet profits are up 5% year over year and S&P 500 net income is up 5.7% as of Q3.   Those who were extremely worried about the sequester in 2012 and the budget deficit decline ended up making a colossal forecasting error as revenues have continued to grow modestly and profits have continued to expand despite the substantial negative decline in the budget deficit.  And that’s largely because the deficit’s decline has been offset by increases in private investment, dividends and some minor help from personal saving and the foreign sector.

On the whole we have to be careful not to look at the equation as a 3 sector model and assume that the private sector can’t become better off without the government’s consistent deficit.  That’s simply not true and the last 2 years have proved this correct as the deficit has declined and the economy has continued to grow and profits have expanded. Additionally, the deficit’s decline in the last two years is largely a sign that the private sector is getting healthier and not necessarily a leading indicator of worse times to come (because it’s been due to tax receipt increases and not spending cuts).  And none of this even touches on the fact that the S&P 500 EPS also includes share repurchases and other index specific factors that the Kalecki equation won’t really help you evaluate at all.

The bottom line – be careful how you analyze the Kalecki Profits equation and understand that there are a lot more moving parts here than you likely think.

I’ll revisit all of this later in the year with an update to where I think profits are headed in 2014.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Looking forward to your 2014 predictions Cullen.

    It starts with the debt ceiling debacle

    I wonder if energy self sufficiency will become a positive tailwind for the next few years, or decades even. Probably acts like a tax cut for everyone.

    The UK gas prices are at 2-3 year lows too.

  2. Excellent post. Do you have a good metric you look at for dividend growth in aggregate? I have a good feel for where investment is running, but dividend growth, less so.

  3. How do we measure profits in the non-corporate sector — either small business, privately held, one-man operations, the cash business? Isn’t that where most business is generated?

    • I think it’s an interesting question, because let’s say you are trying to show that deficits contributed to corporate profits, but what if the deficits contributed to profits in small businesses (etc.) that aren’t corporations — how would you measure that?
      Or if you wanted to make an argument that stimulus spending helped the small business owner — how do you show that?

  4. Excellent points – thanks for the post, Cullen.

    I get exactly the same numbers. Except that I split up the corp sector into dividends (6.2%) and net investment (3.6% of GDP). But here’s the weird thing. 6.2% of GDP is around $1.05trn. And that’s exactly what FRED has for the annual rate of dividends in Q2 (1.037trn to be exact). Now the market cap of the Russell 3000 is $21.1trn, covering 98% of the investable US equity market. So 1trn in dividends would equal 5% dividend yield. However, the Russell 3000 dividend yield, according to Russell Investments, is only 1.9%. So where does the discrepancy come from ?
    Is it 5% earnings yield (= 20x P/E)?

  5. Cullen: I really think we need a five-sector analysis to understand this properly, with financial business broken out separately (so we can see the contribution of financial business to non-fin biz profits).

    This is problematic, of course, for at least a couple of reasons:

    1. How do you disaggregate financial business from rest-of-world? Might conglomerate those into one sector??

    2. FOFAs include hedge funds in households (presumably because they don’t “print money”). How do you disaggregate that? And what gets classified as a hedge fund — what portion of the shadow banking system is included therein?



  6. Gloeschi I agree. There is something weird about the 2Q dividend number. It is dividends not earnings. And, using this number, the year over year growth in dividends was 40%. S&P 500 dividend growth I think was about 20% over the same period. So something unusual (GSE payments?, I don’t know). Q3 should straighten it out. However, if I understand correctly, if you reduce the dividend contribution the personal savings number will turn less negative – so that overall profits remain the same.

    In the same vein, he Kalecki equation is inferring that all the dividends are spent into the economy – becoming a business revenue with no additional business cost – and hence a business profit. However, in reality, a significant amount of dividend payments are not spent currently – they accrue to pension funds, 401Ks, IRAs, “rich people”, etc. I have no idea what this proportion is. Again, this does not impact the overall calculation. If the dividends are not spent, this is reflected in higher (less negative) personal savings. . For example, if the dividends not spent were taken out of the dividend contribution to profits (let’s say half or 3.1% of GDP) and instead counted as savings then personal savings becomes -0.2%. This lessens the “business” contribution somewhat and I think increases our overall understanding. An “identity” can often hide some of the interactions. Thanks.

  7. Cullen – longtime reader, thanks for all your work. This is my first post. I have a question on the dark blue bars in the “profits breakdown” graph. Is the dark blue (net investment + dividends)?

    I have read several articles this year that claim corporate profits as a percentage of GDP are at the highest levels in the post-WWII era. When I add up your numbers, I get +9.1%, which I understand to be net corporate profits as a percentage of GDP for the most recent quarter. Back in March 2012 per the link you provided, Montier was citing corporate profits at about 10.2% of GDP. The economistview article below (May 2013) shows a graph where corporate profits are over 11% of GDP.

    I went to the FRED website and used the following 2 data series:

    a) Corporate Profits After Tax (without IVA and CCAdj), quarterly, seasonally adjusted annual rate

    b) Gross Domestic Product (quarterly, seasonally adjusted annual rate)

    Using these 2 data series, I constructed a chart that was identical to the chart referenced at the economistsview link above. The output was [ (a/b) * 100 ]

    I exported the data from FRED and came up with a number of 10.93 as of April 2013. It looks like there is a lag in the FRED data, as April 2013 is the most recent data point in the exported output.

    Can you help me reconcile your 9.1% number with the ~ 11% numbers I am seeing elsewhere? Could there be some effect of the sequester baked into your numbers? Basically, I am trying to figure out if corporate profits as a percentage GDP might have peaked. Thanks very much.

  8. @CMBS Trader: GDP was revised upwards recently. So that would increase the denominator, making the result (CP/GDP) a bit smaller. Q2 numbers are: Corp Profits $1,821bn, GDP 16,661bn, CP/GDP = 10.9%.

  9. @Gloeschi: right, my number was ~ 10.93% per the FRED website, and I saw 11%+ in graphical form elsewhere earlier this year per the link above. Cullen’s number looks like (5.1% + 9.8% – 2.5% – 3.3%) = 9.1% based on his sector breakout, unless I am not understanding the graph properly? I am just trying to reconcile the difference. Could be splitting hairs, but a couple percentage points as a percentage of GDP seems significant to me.

    • The BEA doesn’t calculate corporate profits according to the exact Kalecki equation so the numbers you come up with from something like CPROFIT are always going to be a little different than just using the equation. Which is another reason here why the Kalecki equation has to be used with some understanding of data unreliability. But it does give us a pretty good approximation of the state of profits.

  10. Cullen,

    What do you use for “Business”. I assume its private investment?

    When I use the Fred data, private investment as % of GDP is currently 16.4%. What am i doing worng?

  11. Nice breakdown Cullen. Remember that the interactions between sectors are fluid. Its always about the Net effect. Decreasing Govt deficits mean the economy is worse than it otherwise would be. Everyone knows that the economy can grow sans a large or growing Govt contribution, just like everyone should know that either collecting more taxes or reducing Govt spending always decreasing Non-Govt income. Sure, there may be an occasion where the private sector has too much income but obviously that is not right now.

    • ” Decreasing Govt deficits mean the economy is worse than it otherwise would be.”

      This is incorrect. The economy doesn’t need a government deficit in order to grow. You M M T people just assume that all government spending is always good and that a budget deficit is always necessary to help the economy. Go ask the USSR or Zimbabwe if government spending got them out of every problem they ever had.

      • This is not ideological. Net Govt spending increases non-govt income. This is not controversial, only ideologues deny such obvious reality. But sure, feel free to delude yourself all want by comparing the US to the Soviet Union or Zimbabwe. The burden is on you to show how decreasing the income of the private sector is beneficial in our current environment.

        • 1) Net government spending does not necessarily increase non-government income. How do you know whether the private sector would have spent in excess of its current income? You don’t know that. You’re just assuming that.

          2) You’re also assuming a current account deficit which can only be true for half of the world at any given time since current accounts deficits need to be funded by surpluses.

          3) And you’re also assuming that aggregate demand is lower than aggregate supply at all times in which case government spending is usually good, but still not always good.

          All three are differing causes of your erroneous generalizations. Deficit spending isn’t always necessary or always good regardless of what M M T and other statist economic schools claim. Deficit spending can be very bad at times.

          • 1) This is a really stupid comment. How do we know that Net Govt spending = Non-Govt income? Because if you receive Net dollars from the Govt, you have them and if you don’t receive net dollars from the Govt, you wouldn’t have that income. My goodness man, what kind of mental gymnastics you have to do to try and refute one of the most basic economic identities (spending = income) there are.

            2)I am not assuming a CAD. The foreign sector is part of the Non-Govt. How large a % of a typical net dollar of Govt spending depends largely on endogenous factors. Nobody forces the world to perform low wage labor to send us consumer goods. Net Govt Spending adds to NON-GOVT income. Try and keep it straight.

            3) More idiocy by you. All of that you’ve conveniently imagined and put into my mouth because you are wrong and thus need to make things up to try and be right. Admitting you’re wrong is good for the soul. I simply said that Net Govt spending adds to Non-Govt income. And of course there could potentially be a time when the private sector has too much income and is driving up inflation to intolerable levels. Is that rime right now? Obviously not, so therefore its good public policy for the private sector’s income to be increased through higher Net Govt spending. This stuff is very basic macroecon. All of which you should already know.

            More straw men. You are so intellectually dishonest its shocking.

            • I guess they don’t teach you much in Marxist economic schools.

              1) The fact that the government spends more than its income doesn’t mean that other sectors aren’t capable of doing so or that they wouldn’t be doing it if the government’s weren’t.

              2) Saying income = spending is stupid. Do you also go around telling people the sky is blue? Thanks.

              3) All spending isn’t good. And it just so happens that government spending has a tendency to be particularly bad.

              Can your Marxist mind digest those ideas? Are you even capable of understanding that government spending isn’t the answer to everything.

                • Why don’t we just agree that if the government writes me a check I will have more income — unless I also lose my job.

                • Yeah, it devolved rather quickly, I just cant stand intellectually bankrupt and dishonest people.

              • 1) More dishonest talk from you, I never said any of that

                2) Thats right, this is exactly why I replied to you in the first instance, I said something that is as obvious and true as “the sky is blue” and you decided to argue with me about it because of you ideological blinders. You should have just not replied and accepted that Net Govt spending adds to Non-Govt income. But thanks for finally agreeing with my original point.

                3) More ignorance by you. I never said all spending is good or equal. Dishonest idiots like you believe that all Govt spending is bad, but what if the majority of the Net spending came from tax cuts? Then it would be the Govt simply withdrawing fewer US$ financial assets from our economy, don’t you think that private sector would be better off with more financial assets right now? Hilarious how stupid you libertarian types are.

                • You’re still having trouble getting your Marxist brain around this. Let me try again.

                  1) If a bond buyer hadn’t been subsidized by the government with a risk free interest bearing bond he/she might have financed a real productive endeavor like a business bond issuance. This is basically what QE is and why it works to some degree. It forces the usual Treasury bondholders to finance real investment and not this government subsidized welfare for the rich that is the US T-bond market.

                  2) The point that spending = income, is so obvious, that I am surprised you feel like you’re so smart for pointing it out. This reminds me of how you MMT people love to point out how the US government has a printing press and can’t “run out of money”. Can you tell me something everyone doesn’t already know?

                  3) Go back and read your first comment. You said: “Decreasing Govt deficits mean the economy is worse than it otherwise would be.”

                  This comment is verifiably false. You admitted so when you agreed with me that all spending is not necessarily good.

                  • 1) Shows a misunderstanding of the nature of reserves. If there were absolutely zero non-bank purchasers of T-bonds because 100% of all money that wants to be saved is going into “productive investment”, then those reserves would still get transferred to securities accounts to earn risk free interest. There is nowhere for those reserves once created to go. Any reserves not needed for settlement balances and transfers will always go into securities accounts as long as the Govt makes T-bonds available.

                    2) If my original comment was so non-controversial, then why did you feel the need to respond? Why do so many people think the Federal Govt’s budgets works the same way as a currency users’ budget?

                    3) Sure, you can parse my words to make them technically inaccurate. I can live with that. Two can play that game so let me rephrase:

                    Decreasing Govt deficits means the Non-Govt has less income than it otherwise would have. My position is that the private sector doesn’t have enough income and spending to realize full employment and output given our current trade and wealth distribution balances. The evidence of this is U-6 of ~14%. Therefore, the Govt should add more income to the Non-Govt.

                    So there, go ahead and try and disagree with that honestly. Good Luck.

                    • 1) T-bond sales aren’t a “reserve drain”. You should know that given the experience with QE so reserve balances have no bearing on T-bond issuance. Besides, reserve balances don’t “go” into T-bonds. You’re misunderstanding market dynamics that Cullen explains all the time.

                      2) Ignored due to stupidity.

                      3) This “Decreasing Govt deficits means the Non-Govt has less income than it otherwise would have.” is not necessarily true. If Joe Blow buys a US corporate bond instead of buying a US government bond then the counterfactual proves that there could be just as much income in the private sector as there is if Joe Blow buys the bond from the government. You don’t know if the private sector could have issued more bonds in an environment where the government wasn’t issuing so many. You just assume so to push your ideological position forward.

                  • 1) I am right about this, you are wrong.

                    2) You are an idiot

                    3) Its just simple accounting. All intra-private sector transactions net to zero. The company issues a liability that also becomes an asset for the purchaser. Net zero. accounting 101. You are going to have to play this game against someone else because you just keep losing.

                    • Auburn,

                      Cullen here. I agree with you for the most part, but on part 3 I will point out that it’s a huge error to focus on net financial assets excessively as MMT does. Our balance sheets are made up of financial and non-financial assets. And if you take the whole world then all financial assets net to zero at book value. In fact, it’s our non-financial assets that matter most in all of this because money and financial instruments are merely claims on real goods and services.

                      That said, even our financial balance sheets don’t really net to zero because most of these assets don’t actually trade at book value. Given the reality of non-financial assets plus market valued financial assets, the private sector has a massively positive net worth regardless of what the govt does. And the non government held domestic NFA represents a measly 4.5% of that balance sheet. So focusing on NFA as MMT does is pretty misleading.

                      In reality net worth = non-financial assets + market value of financial assets. There’s an accounting identity that renders MMT’s obsession with NFA practically meaningless in the grand scheme of things.

                      NFA is a pretty minor piece of the puzzle here, but MMT focuses on it in order to push forward this govt centric agenda of theirs. It’s not helping people understanding these matters.

  12. Could it be Auburn Parks and LVG are both right?

    Government spending: imagine you are selling trucks. You don’t care who buys a pick-up (your neighbor, the bakery around the corner or the municipality for its workers). The demand from the municipality adds to your sales. Government spending = your income.
    It is a completely separate question if that purchase of the pick-up truck was a wise decision (they might have too many already), if debt-financing that truck purchase was a good idea or if the increase in citizen’s safety (snow removal) was worth it.

    One is a static view (gov spending = someone else’s income). The other one is a dynamic view. A dynamic view may also include the increased future tax revenue needed to pay for that purchase (or the debt incurred to finance it). I believe any debt-financed government purchase means less consumption in the future (due to tax hikes), but that’s debatable.

    The sectoral view of the economy is static (looking at one quarter or one year at best). And it doesn’t care about tax policy, future tax rates or monetary theory. It is simply accounting, and it is agnostic to the issues you discuss.

    There are also some lag effects, so corporate profits according to Kalecki do no match exactly the corporate profits reported by BEA, but it comes pretty close (correlation is around 0.5).

    But I am still puzzled about the implied dividend yield of 5% (instead of 2% in the real world). If someone has an idea on how to explain that I would appreciate if you could share.

  13. One has to remember that the Kalecki equation is an identity, not a causal equation. It is similar to a balance sheet entry. This equation has to be complemented by flow equations that show the interaction between the various pieces of the economy, INCLUDING, the flow of credit. Similarly, the Kalecki equation says nothing about the valuation of the markets. We know now that the flow of credit is what really matters for what happens next.