by Philip Pilkington

Here's an interesting little debate from earlier this year that I came across yesterday evening. It is between a number of market analysts over whether the current stock market is overvalued. Why is that interesting? Because the argument is focused on one of the best known foundational stones of heterodox economics: the Levy-Kalecki profit equation.

Weird? Not really. James Montier, a well-known investment analyst at GMO, has been using the profit equation as central to his forecasting work for a number of years. You can see his latest offering here (page 5). Montier's argument is that profits in the US at the moment are heavily reliant on the still rather large budget deficits that are being run there. I made a similar argument on the Financial Times Alphaville blog over a year ago.

This is actually a non-controversial point. Private sector savings are equal, to the penny, to the budget deficit minus net imports. This is intuitively obvious: when the government spends money that money either accrues to a private sector institution within the country or to a foreigner abroad. We then divide the private sector into households and firms and we quickly see that budget deficits are equal, again to the penny, to net imports, household savings and… you got it: profits.

All of this is just basic accounting. The above cannot be in any sense ‘untrue' because this is how the accounting apparatus works. So, why is David Bianco from Deutsche Bank disputing this? Basically he confuses an accounting identity with a behavioral equation. He writes:

This construct assumes that no savings are recycled as investment. This is not a small matter. It represents a major conceptual flaw in this framework, which taints the entire analysis. The equation above would only be correct if all savings were stuck in a Keynesian liquidity trap.

Um… no. It does not assume that. The above equation says nothing with regards to how an increase in savings will effect the level of investment. It is just an accounting identity. As Keynes' protege Joan Robinson argued many years ago in her book An Introduction to Modern Economics (co-authored with John Eatwell):