Friday, 26 August 2016

Rate of Profit, Rate of Interest

The rate of profit and the rate of interest are at the core of capitalism’s dynamic, but there is a huge amount of confusion in what is written on these matters. This article aims to clarify some key points. I outline the relevant aspects of some theories of profit and interest, but focus on how to understand profit and interest rates from the perspective of a Marxist understanding of capitalism. Underlying these abstract concepts are the realities of class and power in the world economy.

Rate of profit calculations
Profitability is obviously important for capitalism. Paying attention to the rate of profit, not just the amount, also makes sense, since this gives the amount of profit per unit of capital advanced, and the more the better. But this simple point hides two important complications.
Firstly, the calculation must be timed. Commonly, calculations are for the rate of profit per year, so that the amount of profit in a year is measured against how much capital is advanced at any one time to achieve it. Other things equal, this also means that the shorter the time period between advancing the money capital, buying the necessary means of production, producing and then selling the commodities at a profit, the greater will be the rate of profit per year. This can make shortening the buying/selling process also appear to be a source of value and profit, not just the production process itself. A quicker method of buying/selling will speed up the circulation process for the producer, raise the amount and rate of profit per year and allow a greater profit to be shared between the producers and the commercial capitalists who are more involved in this process.
Secondly, the rate of profit will be affected by how much of the capital advanced is from the company’s owners and how much is borrowed from banks or other money capitalists providing it with extra investment funds. If we assume a given, annual rate of profit of 10% for the company, then the return on its total investment will also be 10%. But if it has borrowed half its investment funds from banks at a rate of just 5%, or issued bonds with a yield of 5%, then the rate of profit on the funds that the company’s owners have advanced will be higher. For example, for 200 invested at 10%, the annual return is 20. But if the company’s owners have invested only 100 of their own money plus an extra 100 they have borrowed, the company then gets as its profit the 20 total minus the 5 it needs to pay on its borrowings, etc. The result is that its rate of return will be higher: 15 (20 – 5) over the 100 invested, or 15%.
This extra profitability depends on the rate of interest paid on the borrowings being lower than the underlying rate of profit on the total investment. That is not always the case, but it shows how profitability calculations for capitalist owners will tend to change when borrowing funds is taken into account.
What rate?
A company’s borrowed funds raise an ambiguity, one that has not been dealt with well by Marxist theory. If the money is borrowed via bond issues or bank loans, then the payment for the borrowing falls under the heading of interest, so the previous calculation will hold. But if the extra funds come from new money advanced by money capitalists buying any new equity the company issues on the stock market, then how should these extra funds be treated and what is the form taken by the deduction from profits?
If the money capitalists have put their funds into the company’s new equity issue, or even just bought previously issued equity from others, then they own part of the company, just as much as the original owners. To that extent, they will receive a share of the profits in the form of dividends on the equity they own, just like the others. However, there are some distinctions to take into account.
As newer entrants, unless the new equity buyers become big shareholders, they will have fewer claims on the company’s resources through the large salaries they might otherwise get by becoming executives and directors, with special bonuses or other payments. Small-scale equity owners also have little voting power in company decisions, and some of the equity sold and bought may even be devoid of voting rights on these decisions. Insofar as they are in this latter camp, the equity dividends for them are not so different from the interest payments on the company’s bond or bank loan borrowings. But they are still in a different economic situation from bond holders or bank lenders. They benefit from any rise in the price of the equity, and may suffer a loss from a collapse of equity prices. They have none of the usual debt holder or bank lender protection of being first in line for payments, if the company gets in trouble, and their dividends might be zero or very high, while interest and coupon payments are determined at a market level or fixed in advance.
Aside from any possible director benefits, the return on equity for the companies’ owners can be taken to be not only the dividends paid on the value of the equities purchased, but also on the change in the price of the equity itself. So, holding a company’s equity that pays zero dividends may be better than holding one with high dividends, if its equity price has risen far enough above the investor’s purchase price. For example, buying shares in a company at 100 and receiving no dividend for two years will be disappointing for money capitalists. But the outcome will nevertheless look attractive if the company’s share price rises to 150 over those two years, because a large capital gain has been made.
This is accentuated further by the way in which all equity prices (and, indeed, bond prices) tend to rise as interest rates fall, and vice versa, due to the lower, or higher, rates of discount on future earnings by money capitalists. Such calculations show how far capitalist views on what it a profitable investment can become divorced from a measure of the company’s actual return on capital or its underlying profitability.
Company reports usually standardise data with annual rates of profit, and also distinguish the profit due to shareholders after interest on borrowings and other special factors. These commonly lead to different rankings of companies, not necessarily only by their reported profits, but also, especially in recent decades, by the volatility of the returns they get. Extra borrowing usually leads to extra volatility of returns. These are other factors that influence the choices made by money capitalists, and thus the allocation of capital, but they do nothing to change the actual profits produced.

Rate of interest
At first sight, the rate of interest is more easily observable than the rate of profit on industrial or commercial investment. After all, the central bank’s key interest rates are published daily or intra-day, as are the yields on 3-month Treasury bills, 5-year or 10-year government bonds or rated corporate bonds. Nothing similar really happens for measures of company rates of profit. While there are many rates of interest – interbank borrowing rates, government Treasury bill or bond yields, corporate bond yields, borrowing rates for consumer loans or mortgages, etc – they are publicly observable in ways that a rate of profit on corporate investments is not.
How is this problem of many rates of interest dealt with in economic theory? Mostly, not at all. Instead, a sacred ‘rate of interest’ is often used in mainstream economic theory, with few, or no questions asked as to what kind of interest rate is meant. Financial theory may, for practical calculations, distinguish a corporate bond yield or government-borrowing yield, in order to determine the relevant price of a financial security, but there will be no serious investigation as to why this is at a particular level and not at any other. Instead, tautological assessments of ‘risk’ are offered, which make the banal observation that a more risky investment will probably have to offer a higher interest yield. But this does little to get around the problem that much mainstream financial theory, especially for financial derivatives, is based on the idea of there being, at bottom, a ‘risk-free’ interest rate, one that exhibits a zero, or negligible credit risk of not getting repaid by the borrower.
What rate is ‘risk free’? Usually this is assumed to be a government security yield, ignoring the inconvenient fact that governments have also been known not to repay in full. In the case of the US government’s security yields, the nec plus ultra of ‘risk free’ in financial theory, it is conveniently ignored that on several occasions the US government has run close defaulting on its debt repayments, owing to political turmoil in Congress. How far government yields can be seen as objective arbiters of the rate on ‘risk free’ debt is also questioned by a significant bias lower for this rate, especially in financial markets dominated by the major powers. Structural demand for the key government securities, from the domestic banking system, from international investor demand for the global currency security, and sometimes from their taxation policies (for example, exempting capital gains from tax), produces lower yields than would otherwise be the case.
The upshot is that ‘the’ rate of interest is as nebulous as ‘the’ rate of profit. Both sets of rates are determined in a chaotic capitalist market. Are there any laws determining these?

Relationships between interest and profit rates
A common view in mainstream economic theory is that the rate of profit and the rate of interest are either the same, or tend to equality over time. The logic is straightforward, but this logic also highlights the deficiencies of the argument. It is an example of the errors that arise when a focus on appearances is allowed to obscure the underlying processes of the capitalist economy. This happens when the social content of the relationship is ignored, with little attention paid to what the terms in an equation actually mean.
To illustrate this point, and even to make a mild concession to the argument, cast aside the messy reality that there are many rates of profit and many rates of interest, determined by all kinds of market pressures. Instead, assume that there is, in fact, one capitalist market rate of profit (r), available to industrial and commercial capitalists, and one market rate of interest (i) available to those putting funds into banks, buying bonds, etc. The basic case made by modern economics is that there is a tendency for r to equal i.
The rationale for this view is usually given from the perspective of the money capitalist. Let us call him (it is rarely her) Moneybags, and imagine him just sitting there with $1m in cash to play with. So what does Moneybags do with the cash when viewing the opportunities available?
            if i > r, just lend money in the market rather than invest directly in production
            if i < r, then invest in production rather than lend on the money markets
The actions of Moneybags supposedly tend to equalise the two rates, by investing or lending. How? The logic is rarely spelled out, but the mechanism assumed is as follows. If the rate of interest is above the rate of profit, the effect of offering more funds into the money market will tend to depress the rate of interest on loans towards the (lower) rate of profit. Alternatively, if Moneybags invested more in the higher rate of profit available on capitalist production, then that would tend to decrease the rate of profit on that activity towards the (lower) rate of interest on loans. Abracadabra, in a free market the rate of interest will therefore tend to equality with the rate of profit!
There is so much wrong with this argument, despite it often being taken as self-evident, or at least plausible. The problems can be seen in several steps.

Investment and ‘interest’
A money capitalist investor with funds of M can put them into a bank deposit, equity or bond investment, try to start up a business, or invest in someone else’s business. Assuming the investor is attracted by the relative yields, then this looks like a mechanism for equalising r and i, and the previous argument would hold.
However, that assumes there are diminishing returns on the M invested in industry and commerce, or in ‘financial’ ways, so that the flow of M into the different applications of funds will equalise the returns on the funds in each case. Rates of return may not initially move lower when M is applied a number of times to a particular type of investment, but eventually the extra supply of commodities produced, or of funds into an investment area, should presumably lower prices and reduce the rate of profit and also, in the alternate case, the interest return. Yet this seemingly valid logic ignores the nature of the investment that produces the return.
In one case, it is an advance of M to invest in means of production and labour-power to get a surplus value that results in a corresponding rate of profit. In the other case, it is an advance of M on the money markets, into bonds, etc, to get back a value of M plus interest. In the first case, the M may be advanced to expand the circuit of production. This could even raise the rate of profit if it boosted the productivity of a company versus its competitors, although, taken for the economy as a whole and over a period of time, probably not. The real problem for this proposed mechanism occurs for the advance of M for the ‘financial’ investment.
Moneybags wants to get back the invested funds, M, plus interest. But is Moneybags literally a bag of money hovering in the air, having no costs of investment that need to be deducted from the interest received? Also, what if Moneybags also borrows money from others to help fund the investment? Then the net investment return will depend on the difference between the borrowing and lending interest rates, as well as the deduction of his relevant costs. This means that the ‘rate of interest’, seen as a return on money capital advanced, is not as straightforward for Moneybags as the economists’ assertion of the letter i for interest would suggest.
Neither is the ‘r’ for the profit rate unambiguous. Industrial and commercial companies will borrow funds for investment as well as using their own funds. This means that their net profit is reduced by their interest payments; to give what Marx called the ‘profit of enterprise’. This latter profit is best measured over the money advanced by the industrial and commercial capitalists to get their ‘rate of profit’, but that will generally be a different number from the rate of return on the investment as a whole, as explained earlier.
The industrial and commercial capitalists will tend to borrow more, the lower is the rate of interest on borrowing versus the going rate of profit. They might also stop any extra borrowing when the rate of interest rises to equal the rate of profit that extra investment funds could generate. Yet, while that looks like a possible market mechanism for tending to equalise the rate of interest and the rate of profit, it is at best only a partial one. For example, companies would not borrow indefinitely with a lower rate of interest than the rate of profit. To do so would greatly increase their ‘leverage’ and expose them to the risk of having to service debt and pay interest even if the conditions of profitable production deteriorate. For such reasons, stockmarket investors usually frown upon highly leveraged companies.
In addition, there is the point, explained in my book, The City,[1] that the ‘profit rate’ of financial firms, such as banks who can create their own financial assets, or who depend upon attracting funds from other money capitalists and savers, such as asset managers, cannot sensibly be compared with the profit rate of industrial and commercial corporations advancing capital for their business. It is not comparing like with like.

In Marxist theory, there is no law determining the rate of interest, while profits are determined by the surplus value extracted from productive workers. That profit is measured over the capital invested, to determine a rate of profit for the system as a whole, and the profit remaining to the productive capitalists is determined after paying the amount of interest. [2] The only barrier to the rate of interest is that it cannot be sustained at a level that eats up all the profit of productive capital. In recent years, ‘real’ rates of interest have been negative (when compared to inflation levels), and have even been negative for some rates in nominal terms, but no statistician has so far claimed that corporate profitability has become close to zero or negative for the economy as a whole. This gives empirical support to the argument in this article that there is no equalisation of the rate of interest and rate of profit.
Developments in capitalist society mean that the 19th century picture of the industrial capitalist versus the money capitalist and, correspondingly, the rate of profit versus the rate of interest have taken on a new form today. While it is possible to identify capitalist entrepreneurs who have founded companies, from James Dyson (vacuum cleaners) to Mark Zuckerberg (Facebook), most of these have also evolved into being financial entrepreneurs, using borrowings from capital markets and financial operations to boost their market status and power. It is commonly the case that ‘entrepreneurs’ these days cannot readily be separated from ‘financiers’, given their often multiple shareholdings and other financial interests; still less can the initial investors in their projects from the financial elite be considered under the same heading as Marx’s industrial capitalists.
So there is not any longer, even if there once was in Marx’s time, a distinct class of ‘money capitalists’ versus the rest of the capitalist class. Individual capitalists will often have a portfolio of more important and less important holdings in companies, ones they pay more attention to and others, ones that are industrial, commercial or financial, together with the additional assets they hold in the form of government and corporate bonds, money market securities, bank deposits and so forth.
The activities of asset managers, insurance companies and pension funds complicate the situation further. In the rich countries, where financial operations are more prevalent, a significant proportion of the population indirectly owns a large share of corporate equity. No individual among these feels in control. Rightly so, since their monthly payments or accumulated savings are used to boost the corporate elite. But they nevertheless also benefit from and have a stake in the fortunes of the capitalist corporations in which they have invested. This has an impact on the politics of the populations concerned. But I do not cite this as the only political problem faced, since in the richer, imperialist societies the poorest will also commonly be among the most aggressive supporters of their state’s power.

Tony Norfield, 26 August 2016

[1] See here.
[2] Even this simple summary ignores the question of rent on land ownership, dealt with in the latter parts of Volume 3 of Capital. In this article, I do not cover the separate question of the tendency of the rate of profit to fall. My book, The City, discusses how measures of the rate of profit are impacted by financial developments, state intervention and, especially, by the position of a country in the world economic system.

Sunday, 21 August 2016

World Beaters

With the close of the Rio Olympics, I was surprised to note a pretty close correlation between the ranking of countries who won gold medals in Brazil with ... the power ranking of the respective countries in the world economy! The data are taken from the official Olympic data and from an index that was updated for my new book, The City: London and the Global Power of Finance.

My book gives a chart derived from 2013-14 data for the top 20 countries for their GDP, FDI, global use of their currencies, their military spending and prominence in international banking. The rank is determined by the score that each country has under each of the five measures. It gives a score of 20 for each country in which it is top, and if one country is half the level of the top country, then it gets a score of 10, and so forth. Below is a cut down version of the chart showing the top 10 countries in the ranking:

Top 10 Power Index Ranking

Countries are listed by their two-letter ISO code, so that GB is the UK, CN is China and DE is Germany, for example. In recent years, China has risen in the rankings, based upon its GDP growth and other measures. The US, not surprisingly, is top overall, although it is second to the UK in terms of international banking. In the power chart, the order of the top three is: US, UK and China.

For the Top 10, this power ranking picture is very close to the Olympic gold medal results! To standardise the two pictures, I have made the US gold medal score (the highest at 46) equal 100, while the UK's at 27, in second position, is then equal to 59 (being 59% of 46), and so forth. The outcome for the top 10 gold medal-winning countries is below:

Top 10 Rio Olympic Gold Medal Ranking (Index, US = 100)

(Note, this was updated on 22 August to correct the US number from 45 to 46)

Compared to the power ranking, South Korea (SK) and Russia (RU) make it into the Top 10 for gold medals, while the Netherlands (NL) and Switzerland (CH) do not. But the top three are the same, and in the same order, in both rankings. Germany, France, Japan and Australia also make a showing in both Top 10 rankings. South Korea makes it into the gold medal ranking, but not the power ranking top rank.

It looks like having an ability to be first in an Olympic event has a close relationship to a country's position in the world economy, at least for the top countries in each ranking.

One aside on the UK is that there has been a ruthless 'medals mean money' approach to granting money to Olympic sports. In unashamed state planning, the UK's National Lottery has done much of the funding on this basis. This diverts money from the regular subscriptions of the masses betting each week, and their need for entertainment, into a national success story. As one might expect, this is principally enjoyed by the privileged classes, exemplified by the funds available for 'horse dancing', otherwise known as dressage.

Tony Norfield, 21 August 2016

Sunday, 14 August 2016


On Thursday, 11 August I was interviewed by George Galloway on RT’s regular ‘Sputnik’ programme. The 15-minute discussion covered some topics in my book, The City, plus finance and government policy in the economic crisis. The video link is here.

Tony Norfield, 14 August 2016

Thursday, 4 August 2016

The Bank of England's National Brexit Policy

The news media has highlighted how the Bank of England's policy move today was the first cut in UK interest rates since 2009. But this completely misses the important points. By itself, the 25bp drop in the official Bank Rate from 0.5% to 0.25% is largely irrelevant, either as a policy move or as having any real economic impact. Instead, the significant policy decisions are elsewhere.
First, is the Bank of England's move away from its official policy target of stabilising CPI inflation at close to 2%, usually taken as meaning over the next two years. Despite the drop in sterling's exchange rate, and the expectation that this will boost UK inflation, the Bank has decided to look further ahead and cut rates today in the expectation that weaker UK economic demand, employment and output will reduce inflation again by the end of the next three years!
This is another sign of the flexibility of policy in this chronic crisis. Of course, it would have been madness to raise interest rates in the wake of the Brexit vote and the likely impact on the UK economy. However, this policy decision shows how far the rejection of previous policy norms has gone. What it really boils down to is the view that wage demands will remain limited, despite a fall in living standards, so the problematic inflation for capitalists, that of wages, will not actually be a problem. The new Bank of England policy is now closer to that of the US Federal Reserve, which has a more mixed inflation/growth/employment mandate when setting US interest rates.
Second, is the extension of Quantitative Easing (buying up financial securities from banks and other private sector holders, to put cash into the system). Until now, the Bank of England had bought £375bn of UK government bonds, but had kept that figure unchanged in recent years. In the early years  of the 2007-08 crisis aftermath, it had had only a small, temporary holding of private sector bonds. That will change with the new policy. Further government bond purchases will occur, an announced £60bn that will take the total to £435bn. All this will do is reduce government bond yields further, as happened today, and further undermine the viability of pension schemes, both public and private, increasing their funding deficits. However, the new angle is for the Bank of England to purchase up to £10bn of corporate bonds.
The latter move is extraordinary, especially in the way the Bank of England poses it as looking to "purchase a portfolio of sterling non-financial investment-grade bonds representative of issuance by firms making a material contribution to the UK economy, in order to impart broad economic stimulus". Leave aside the point that the size of the corporate bond market targeted is only around £150bn, and that they hope that BoE purchases will increase the prices and lower the rates on eligible bonds, also reducing these companies' demand for bank loans that could then be taken up by others, especially smaller companies. The key point is that the Bank of England has now entered the process of deciding to buy bonds only from firms that make a 'material contribution to the UK economy'!
I cannot emphasise enough how far this policy contradicts all the logic that we have heard for decades from policy makers, central banks and governments, of how it is necessary to compete in 'free and fair' global markets. Here we have a central bank from a country at the centre of the world financial system explaining that a part of its new policy is to discriminate in favour of companies that are nationally valuable.
If anyone doubted that the pressures of the chronic global crisis are forcing the major powers to reconsider their positions, and that they are abandoning policies of cooperation - admittedly, cooperation that has been mixed with intense rivalry - then they should consider this latest Bank of England move. The significance is not indicated by the relatively small scale size of the £10bn funds, but in the outlook it offers for future imperial policy.
Tony Norfield, 4 August 2016