Thursday, July 15, 2010

The Final Onion

According to Keen, one of the 16 people identified as having anticipated the global financial meltdown is Kurt Richelbacher.

Kurt R... Despite my bad memory, the name was immediately familiar. Rummaging through my bookshelf, I found the old magazine. An advertisement really, a magazine-size advertisement from a company called Investment Rarities Incorporated. (I don't mean to advertise for them here, but I respect information sources.)

On page 5 is a Q&A with Dr. Kurt Richebacher. No "L" in the name; but it's gotta be the same guy. Richebacher's first answer is the reason I saved that magazine:

Q: Give us the cause of the profits problem.

A: Corporate cost cutting, for one. The widespread measures that individual firms take to improve their own profits have, in the aggregate, the opposite effect on the profits of other firms. Business spending is the key source of business revenues, not consumer spending. A retrenchment in business spending cuts business revenues. Higher profits and higher prosperity cannot possibly come out of general cost cutting.

A really good statement. The first sentence of the answer gives us Dr. Richebacher's sense of priorities. The last sentence is almost Keynesian in its clarity of thought. The second is a nice expression of the paradox of deleveraging or the paradox of thrift. And the third sentence is the topic here today.

Business spending (not consumer spending) is the key source of business revenues.

My posts of 23 and 24 June refer to total corporate deductions in the amount of $25.5 trillion (for 2006) and $26.97 trillion (for 2007). But the U.S. GDP in 2006 was $13.4 trillion, and in 2007 under $14.1 trillion. Corporate tax deductions were nearly twice the nation's GDP each year. And those numbers are typical.

Maybe people know this, I don't know. I've known it for a long time, and I still find it surprising. And by the way, that's just corporate tax deductions. Doesn't include tax deductions of non-corporate businesses.

How can this be?

Ever peel an onion? There's a big difference between a solid, baseball-size onion and the first thin dry layer that comes off in your hand. Only the thin dry layer is taxed. The rest is all tax deductions.

Imagine an economy where everybody manufactures artificial onions. There are many different companies involved; each company adds a new outer layer and sells enhanced onions.

The "value added" by each company is the new outer layer. But no company sells only the outer layer. Every company buys onions, enhances them, and sells enhanced onions.

The final onion, with all the layers on it, is the total value added. All the work that everybody did is in there. The final onion is GDP.

But it doesn't get sold only once. Somebody makes the juicy center, and sells it. Somebody adds the first layer, and sells it. Somebody adds the next layer, and sells it. Somebody adds the next layer...

If there are a dozen layers to the onion, the thing gets sold a dozen times. If each stage of production adds a dollar to the price of it, the final sale price is $12. But the total spending is 12+11+10+9+8+7+6+5+4+3+2+1.

The total spending in our economy is much the same as the total spending on that onion. The final sale price or the "final spending" is what counts as GDP in our economy. But beneath the outer layer there are many preliminary or intermediate transactions. Each of those adds a little to the final price, but much to total spending.

When you look at the "total" spending involved in all of those transactions, it is a big number, much bigger than the "final" spending number. Most of those transactions are business-to-business transactions, the ones that add layers to the onion. And most of those payments are tax deductible. And that is how total corporate tax deductions got to be so much bigger than GDP.

But when it comes time to cut business spending, business-to-business transactions take a big hit. As Richebacher says, "A retrenchment in business spending cuts business revenues." Corporate cost cutting cuts corporate income, pinching the thin dry layer of profit.

It is the downtrend that spreads disaster. The solution is to keep the economy growing. Richebacker says it best: "Higher profits and higher prosperity cannot possibly come out of general cost cutting."

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