Stylized Facts

In order to construct the profit index the following proxies for the four determinants of profits are used[4]:

I: Gross Fixed Capital Formation DF: Government Expenditure[5] BPS: Current Accounts

SW: Gross Household Savings

As can be seen in figure 1, the profit index is quite volatile, ranging between 30% and 40% of GDP. The first consideration is that heterogeneous economic structures exist in each economy, and a country may have found its own balance although it differs remarkably at the level of profits as a share of GDP. The type of equilibrium depends upon the intrinsic features of the economy, and it can be divided into two types of growth model: a profit-led growth and a wage-led growth (Badhuri and Marglin 1990; Lavoie and Stockhammer 2013; Stockhammer and Onaran 2013).

Insert about here Figure 1 Profit Index at Country Level

What matters is not the absolute value of the index, but its growth above the growth rate of the economy, and how investments respond to an increase in the four determinants of profits. Consequently, this paper addresses the question by pooling together core Euro Area countries with common growth strategies. The analysis is based on the categorization developed in Stockhammer and Wildauer (2016) and further investigated by Covi (2017). In this conceptual framework, France, Italy, Spain, and Portugal comprise the Southern region with debt-led growth and a wage-led demand regime, whereas Germany, Netherlands, Belgium, and Austria comprise the Northern region characterized by export-led growth and a profit-led demand regime. These two sets were initially put forward given the opposing pattern of the trade balance - the third determinant of profit - for which the former group has a deficit and the latter a surplus. According to this definition, figure 2 shows the evolution of the profit index at the region level[6].

Insert about here Figure 2 Figure 2: The Profit Index

As is clear, up to 2003, the Southern region outperformed the Northern region profit index by 2% of GDP. However, from 2003 on, the Northern outpaced the Southern region. During the boom period preceding the financial crisis the gap was 2-3 percentage points of GDP, whereas in 2016 and during the period 2009-2011, it reached 5%. Moreover, the real gap is even larger, since the increase of the profit index in the aftermath of the financial crisis in the Southern region was due to falling GDP, i.e., a decrease in the denominator.

In order to understand what drives the profit index, its determinants need to be looked at on the disaggregated level, as shown in figure 3. It is evident that investments in the Southern region underwent a boom period, increasing from 21.5% of GDP to a peak of 24% in Q4-2007. Nevertheless, as the crisis hit, investments fell sharply, reaching a level 2% of GDP lower than in 2000. Clearly, investments in the Southern region have yet to recover, while in the Northern region they grew at the same pace as GDP, remaining flat as a share of GDP over the entire period. According to Minsky’s theory, government expenditure should have expanded as much as the fall in investments, but didn’t, only increasing by 2% of GDP, not enough to counterbalance the 4% fall in investments. On the contrary, in the Northern region, government expenditure increased more than proportionally than the fall in investments. On top of that, the third

determinant of profit - current account - underwent an asymmetric pattern, working as an amplifier of the profit index in the North and as profit-drainer in the South. Only in 2016 did the current account of the South achieve an overall surplus, after fourteen years (2000-2013) of chronic deficit. Nonetheless the differential with the Northern region is still wide. Although it has decreased since the 2008 peak of 10% of GDP, it still stands at 7%. This is a key point for the analysis since it is the driving force of the large divergence in the profit index between the two regions. Moreover, given the fact that expected profits are the incentives needed to stimulate current investments, this may only further widen the gap in growth potential between the two regions, increasing the likelihood of self-reinforcing divergence.

Insert about here Figure 3

Evolution of the Four Determinants of Profits

Finally, savings out of wages decreased by 1-1.5% over GDP in the Southern region, sustaining the profit index but not enough to keep consumption stable after the crisis, with a decrease of 5% in its aftermath. In contrast, savings in the Northern region remained stable over GDP, and this is consistent with the growing pattern of private consumption, which did not undergo a fall after the crisis.

Figure 4 shows the causes of the collapse in investments by private non-financial corporations and households. First of all, corporate investments account for half of the overall investment volume, while household investments account for one-third[7]. For the former, the fall after the crisis was steeper in the South than in the North; moreover, in the Northern block corporate investments recovered faster than in the South, although both remained below the pre-crisis peak. In contrast, household investments had the opposite pattern: boom and bust in the South, flat in the North. Clearly, the inverse-U pattern in the South resembles the pattern in overall investments, suggesting that household investment was - à la Minsky - a non-negligible driver of the investment cycle.

Insert about here Figure 4 Investment Decomposition

The stylized facts presented here and the existing relationships between the four determinants of profits and business cycle fluctuations caused the large divergence in the capacity of the economy to produce and create employment. As figure 5 shows, the gap in GDP growth since the crisis kept on widening, reaching almost 7% in 2016.

Clearly, the Southern region has yet to recover the pre-crisis peak in output, while the North achieved this in just a few years. The second divergence is related to the unemployment level, which is 7.5% higher in the South than in the North. The point is not when the unemployment rate returns to the pre-crisis level, but whether, due to the loss in production capacity, it has become a structural feature of the Southern region, creating a new equilibrium (Ginzburg et al. 2013). Hence, the primary question is whether these two diverging patterns are self and mutually reinforcing, that is, current forces in place may work for divergence and not against it. Household investment in the Southern region seems to strongly depend on the state of the economy, and unemployment appears to be an amplifier of the business cycle, reinforcing the boom and exacerbating the bust. By analysing the structural differences between unemployment in Europe and USA, Blanchard and Summers argued that “long-run equilibrium depends on history…and that identifying the circumstances under which persistence is likely to arise is crucial” (1986: 71). For this purpose, in the following paragraph a SVAR methodology attempts to estimate these forces in order to compare them in the two regions and clarify the nature of the massive divergence.

Insert about here Figure 5 The Divergence