The Rate of Profit and its Impact on Investment and Growth

A central tenet of classical (and neoclassical) economics is the profit-led character of capitalistic economies. This means that, in these views, the presence of a high rate of profit is held essential for promoting investment and growth. This view was shared also by Marx, because he largely based his theory of surplus and exploitation on Ricardo’s labour theory of value. 

As for Keynes, he considered central for economic cycle the notion of the marginal efficiency of capital (MEC), which is defined as the marginal and comparative profitability of investment in relation to the real rate of interest.  On the other hand, he introduced a concept at variance with MEC, namely, the central notion of “animal spirits”, that people engage in economic and social activities not only out of strictly economic calculation but also irrationally.  Another reason that led Keynes to mitigate the all-important role of profit rate was his awareness that our economic systems are also consistently wage-led. This happens because, as widely investigated, the propensity to consume ─ and, hence, the corresponding value of the income multiplier ─ of the working classes is far higher than that of entrepreneurs. 

Despite these qualifications, the mainstream idea of a profit-led economy became (and still is) dominant in the neo-liberal counterrevolution that started in the 1980’s with Reagan’s and Thatcher’s governments. The neo-liberal agenda that started in the 1980s, by increasing economic inequality and the precariousness of life conditions, severely harmed the capacity to consume of middle-lower income classes, with negative effects on income multiplier.  The neo-liberal agenda, including high real interest rate, badly affected the marginal efficiency of capital and hence triggered the huge financialisation of the system. 

Especially In the last 30 years, profits have been most often high (especially for large corporations and financial investment), but this rarely warranted an increase of productive investment, which often declined. This took place also as a result of a structural tendency towards an increasing “productivity of capital” and the corresponding relevance of the “immaterial and intangible” side of production.  Especially in large corporations, investment decisions are made by managers rather than by classic entrepreneurs. And, as investigated by a wide literature, the managers’ goals relate much more to the firms’ expansion than to profit maximization. 

Public spending has constantly increased, with various ups and downs, in the post WWII period, not only for the pressure of lobbies, but for the more substantial reason that it constitutes - in addition to providing public goods necessary for the development of the system - a central and irreplaceable component of effective demand (the "crowding out effect" is a kind of classical and neo-classical wishful thinking).  The same applies for credit creation, which is a relevant means for creating effective demand. This last aspect leads one to doubt a sharp relation between investment and rate of profit, because investment is in general heavily financed by credit creation. 

Many profit-led supporters stress that the economic take-off that came about in backward economies very often witnessed a strong correlation between rate of profit, investment and growth. This aspect has driven many to consider economic inequalities as a necessary price for development. This argument, however, is much weaker than it appears at a first sight. First, investment expenses were made possible by the market expansion, especially abroad, and were financed especially by credit creation. 

Certainly, profits were high as a result of the increase in productivity and in monopoly power, and partly helped to finance investment. But this does not imply that profits “caused” investment and growth, as it is much more likely that the inverse relation applied: namely, that high profits were a consequence, rather than a cause of investment and growth.  

But more importantly, it seems pertinent to note that such early stages of economic development are, for a number of structural reasons, gone forever. There is nowadays going on a structural transformation of the economic systems towards some kind of steady state (and probably de-growth in the middle-long run), where the “mixed forms” ─ in which many actors and motivations are at play ─ of economic action will grow more relevant.   

As already noted, in investment decisions a central role is played by the so-called "animal spirits” (behaviour based on non-economic motivations). Following these insights, Keynes, in the final chapter of the General Theory welcomes a situation where ─ through a policy of sharp reduction of the real interest rate ─ the profit rate would become substantially lower than ordinary level.  

As for the Marxist theory of exploitation based on Ricardo’s labour theory of value, we believe that exploitation can be much better appraised by considering the reality of huge asymmetry of power in labour market. As underscored, for instance, by John Rogers Commons, an isolated person offering job to a firm of, say, 1000 workers, has a contractual power equal to 1/1000, as the management with which (s)he is dealing represents the entire capacity of the firm.  

In conclusion, the supposed necessity “to restore the rate of profit” in order to ensure investment and growth is unrealistic, and dangerous for the building of a progressive economy.  Several left-oriented people accept this theory as it constitutes the basis of Marx’s theory of exploitation. However, the acceptance of this classical hypothesis makes it more difficult to effectively react to the neo-liberal claim that all that matters for economic recovery is the reduction of taxation and real wages.   

Hence, it seems much more promising for heterodox economists to rid themselves of classical influence and build a better synergy between the various heterodox streams: in particular, original institutional economics, Post-Keynesian theories, Marxism and other theories of social justice, theories of environmental sustainability. These synergies, by helping better understand the complexity of real world and the effects of different policies can help frame a progressive and sustainable economy increasingly based on labour and participation. 

Arturo Hermann is Senior research fellow, Italian National Institute of Statistics, Rome.  

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Arturo Hermann