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.
Conclusions
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
[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.
