Liquidity Provision, Not Liquidation

Accounting Profits Can Be Different Than The Health Of The Economy

“The general theory of economic equilibrium was strengthened and made effective as an organon of thought by two powerful subsidiary conceptions—the Margin and Substitution. The notion of the Margin was extended beyond Utility to describe the equilibrium point in given conditions of any economic factor which can be regarded as capable of small variations about a given value, or in its functional relation to a given value. The notion of Substitution was introduced to describe the process by which Equilibrium is restored or brought about.”

• John Maynard Keynes, “Alfred Marshall”

I used to watch a show called Ramsey’s Kitchen Nightmares. In this show, super chef Gordon Ramsey would consult with failing restaurants. Often he would teach basic management lessons, such as demand planning and the importance of courting new customers. One restaurateur was washing her own dishes rather than hire a dishwasher, not realizing as a manager she needed to target costs rather than cash outflow. This story will come back later.

My favorite episode was about a woman who was an extremely talented chef occupying the safe niche of producing authentic American soul food in London. She was told by the bank to cut costs and raise prices to increase profitability in return for a loan. Ramsey advised her to ignore the bank, because they are a bunch of assholes who don’t know shit. And it’s true, no better sign of poor management than leadership cutting costs with no specific vision.

I like to write about management and the economy rather than “economics”. But economics has a real perspective on the simple management issues raised by Mr Ramsey. The perspective is outlined in abstract by the Keynes quote above. This perspective is particularly important when times are hard: depressions, recessions and panics.

When the price of strawberries goes up, the quantity of strawberries purchased will go down. This is obvious whether you are Joe Schmo on the street or berry economist Benjamin Graves. But Graves has a small advantage of Mr Schmo. Schmo believes the price of strawberries goes up then people will buy less strawberries because purchasers will be less able to afford them. He might even think this is a dull truism.

But economic theory largely denies this analysis. The quantity demand effect of a changing price on the purchasing power of a firm is the so-called “income effect”. The income effect is variable. Large direct purchasers of strawberries include retailing firm Wal Mart and agricultural cooperative Ocean Spray. In terms of income effect, these firms could have different reactions to increasing strawberry prices. Wal Mart might see the income effect of an increasing price of strawberries as a reason to cut back on other berry purchases and consolidate in the high profit strawberry market (other considerations could of course overcome this). Ocean Spray however would almost certainly see rising strawberry costs as a reason to consolidate back to their cranberry market home even if just considering the income effect.

Okay, that was a bit much. But in this case we actually can do more than say “It’s complicated.”! The genius of Eugenio Slutsky (not to be confused with CVAR hero Eugenio Colorni) was to show that all changes in quantity demanded can be partitioned into two linear parts: a substitution effect and the above mentioned income effect. The substitution effect says that if the price of strawberries goes up relative to substitute goods, then the purchaser (at a fixed level of wealth) will derive their fruit service from the substitutes to the extent possible. That extent possible is the so-called margin. Thus we finally have all the pieces that Keynes gave us in the paragraph above.

Insofar as they are an instructor of man, the economic theorist must in the first place believe that their students are all but entirely unaware of substitution effects and must be pulled into the light by way of diagram, example and algebra. When in the pulpit, the economist preaches that the economy consists entirely of needed services which can be fulfilled by infinitely various physical means. Thus, the sermon continues, the margin is in the first place psychological: the ‘choice’ (in scare quotes) to make one substitution (strawberries for raspberries) and not another (strawberries for lingonberries). The costs & prices that enter into substitution decisions have money *units* but are not generally a publicly quoted price on a formal market. Going back to the first example, the poor manager that Mr Ramsey was consulting washed her own firm’s dishes because she was making decisions based solely on cash flow rather than on costs. Thus her firm was less profitable than it could have been.

So two cheers for the margin and substitution. But Keynes reminds us that the economic theorist cannot remain solely with the psychological margin. They must build the notion out into a complex system of relations, relations that do intersect cash flow, material goods and other aspects of the quantifiable world. The margin is only expressed by actual substitution, which is not psychological but a change in the state of the actual world. To try to remain with solely psychological margins is like remaining with the question “Where is the sun?” unable to build up to a question with a more definite answer such as “What is the terracentric position of the sun?”. These relations, though shallower than the cost insight, give the actionable content of any economic theory and thus it is by these relations that a theory is judged, not the theory’s depth:

“According to Malthus’s good common-sense notion prices and profits are primarily determined by something which he described, though none too clearly, as ‘effective demand.’ Ricardo favoured a much more rigid approach, went behind ‘effective demand’ to the underlying conditions of money on the one hand and real costs and the real division of the product on the other hand, conceived these fundamental factors as automatically working themselves out in a unique and unequivocal way, and looked on Malthus’s method as very superficial. But Ricardo, in the course of simplifying the many successive stages of his highly abstract argument, departed, necessarily and more than he himself was aware, away from the actual facts; whereas Malthus, by taking up the tale much nearer its conclusion, had a firmer hold on what may be expected to happen in the real world.”

• John Maynard Keynes, “Thomas Robert Malthus”

Yes, often a shallow but stable function serves science more deeply than a tangled web of causes. Causal analysis and depth is good, but comes at certain expenses. A well known economic example is found in the marginal rate of transformation faced by the producers of substitute goods, say frozen concentrated orange juice and fresh orange juice. In a so-called “competitive market” (i.e. where purchasers are indifferent between different producers of orange juice including between in house and out of house production), the marginal rate of transformation between fresh and frozen concentrated orange juice at the currently installed capital base is equal for each producer and equal to the relative price. But this rate does not cause the relative price. Rather, the price is determined by whoever happens to be the marginal purchaser on the order book right now.

In fact, the installed base of capital is itself merely a way of going long the goods & services said capital can supply when mixed with labor. The service of that capital is a substitute for writing a future contract with different risks. If the entrepreneurial opinion shifts, then they will transform that long position to a short. In the case of going long by purchasing capital, they will do so by selling off capital equipment for money or “liquidating”. Often highly specialized equipment will have low or no value on the open market. This is one of the risks involved in investing in plant.

A good real life example happened recently in Texas. The Texas Legislature offered $5B loans at low interest rates to build a gas power plant. The Texas legislature favors gas due to them being rats. They didn’t find any takers. At the end of the day all you get out of taking the loan is a gas power plant. Who wants all that trouble? Capital good risk and uncertainty is basic to the megaproject approach. In fact similar, though more extreme, considerations stymie nuclear plants. No nuclear plant has been delivered on time or on schedule in the known history of the world. This problem is getting worse in the US and Europe. Contrariwise, you can build out wind/solar and battery parks with off the shelf parts. Thus liberalized markets like Texas vastly prefer to build wind/solar and battery parks. I don’t report this as a statement of preferences about energy production but as a set of well known facts.

Once again, we must leave the economy for a bit and come back to “economics”. You see, the pull of the subjective world of profit is exactly that it is an accounting variable: subjective incomes “add” and subjective costs “subtract”. One could, in principle, discover exactly the costs a restaurateur is bearing by washing her own dishes and compare the cost of hiring a dishwasher. This unexpected ability to compare a subjective cost to an expected cash outflow is due to the judicious choice of units, the famous “measuring rod of money”. By judiciously choosing units income and costs (and their difference, profit), however subjective, sum within a firm and across firms. Thus one can speak of the source of profit on a macroscopic scale. The sources of profit are in some sense the “positive sum” parts of the economy. Jerome Levy and Michael Kalecki, following Maynard Keynes’ judicious choices of units, showed that the sum of profits can be meaningfully distinguished into two parts: net investment and net dividends (net over non-business saving). Investment is the “increment in the value of the entrepreneur's equipment beyond the net value which he has inherited from the previous period”, which is to say the negative of the user cost of using capital. Dividends are the distribution of profits paid to households.

The Kalecki-Levy equation may seem unintuitive, since investment and dividends seem like money spent by a company. But consider what happens to the dividend: the receiving household must save or spend. By netting dividends over non-business saving, we must be counting money that is being invested in firms by households. The partition makes sense when one realizes that the receiving of a dividend and the decision to save are separate acts: “To begin with, [individuals] do not know what their incomes are going to be, especially if they arise out of profit. But even if they form some preliminary opinion on the matter, in the first place they are under no necessity to make a definite decision (as the investors have to do), in the second place they do not make it at the same time, and in the third place they most undoubtedly do not, as a rule, deplete their existing cash well ahead of their receiving the incomes out of which they propose to save, so as to oblige the investors with ‘finance’ at the date when the latter require to be arranging it. Finally, even if they were prepared to borrow against their prospective savings, additional cash could not become available in this way except as a result of a change of banking policy.”.

Take the example, Spotify reporting profits for the first time in its 19 year history. The decision to reduce the level of investment that it had last year to record an accounting profit had nothing to do with Spotify’s massive and stable income but reflected the strong growth in wages over the course of the Biden administration and persistently high interest rates. Spotify’s decision to prioritize short term profits (for the first time ever) is the result of expectations of growing wages and that the interest rate will remain above the marginal efficiency of capital (MEC) in the future.

Now, dividends are paid out of profits. Thus the ultimate source of all profit (less net dividends) is net investment: whether the creation of more solar power plants or the creation of more financial assets (i.e. deficit spending). We have previously written much about investment as the point at which the subjective cost/profit world hits the objective liquidity/cash flow world. From the source of profits point of view, one sees that investment is the positive sum part of the economy.

From a macrofounding perspective, we can look at whether Spotify’s recent cost cutting drive has created profits or merely taken profits from other parts of the economy in zero sum. Obviously, cutting costs is not an investment. Thus the only way that Spotify could have created profits is through its dividends. Overall, dividends have increased while non-business savings have decreased, suggesting that this is a major channel for profits currently. Thus Spotify is probably not engaging in a beggar thy neighbor profits strategy.

However, moving from the short run to the long exposes a problem. If Spotify is predicting that interest rates will remain so high that long term investment is no longer worthwhile, then Spotify is eating its seed corn. As Seeking Alpha’s Motti Sapir says: the best case scenario for Spotify in this environment is successful price hikes, a sudden revaluation upwards of podcasts and audiobooks by consumers or an amazing new technology. Spotify’s strategy signals that it does not consider the latter two likely. I think this reflects the general consensus of the business world, thus the general strategy of creating profits via the dividend channel.

But increasing profits by charging customers more for the same product is not sustainable. The only sustainable source of profit is therefore investment. Reducing the interest rate allow for lower MEC plant to be built and thereby investing more (especially in a green electric grid) would shift the creation of profits to a sustainable business environment. The moral of all of this is really quite simple: we need liquidity provision in the short run if we are to avoid liquidation in the long run.