By John Carney, Senior Editor, CNBC.com NEW YORK ( CNBC) -- Neel Kashkari is turning out to be a very interesting guy. Okay. Okay. A lot of people would argue that Kashkari, the former Goldman Sachs banker turned Hank Paulson Treasury Department TARP right hand man turned Pimco stock picker (official title: managing director and head of global equities), has always been interesting. Even back in high school, young Neel was ticking off his snobby school teachers with his pro-Republican views. But Kashkari's latest essay for Pimco's "Equity Focus" column is interesting in an entirely new way. It breaks out of the usual mode of political debate between allegedly pro-business Republicans and pro-government Democrats by pointing out that the source of the unusually high corporate profits over the last couple of years has been the government's deficits.
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Given the importance of corporate margins on today's stock prices, it is worth taking this review further and also considering a macroeconomic perspective on margins.
Some investors have used the Kalecki profits equation to break corporate profits into its fundamental macroeconomic elements, specifically:
Profits = Investment - Household Savings - Government Savings - Foreign Savings + Dividends
From this equation, investors can see that corporate profits have expanded to such a large share of GDP due to large government deficits. Therefore, if the government implemented a deficit reduction plan, corporate profits could suffer.To make this a bit clearer, it helps to remember that in each sector -- household, government, foreign -- "savings" is the difference between income and spending. So, household savings is the difference between what households earn in income and what they spend into the economy; government savings is the difference between what the government taxes and what it spends (currently a negative number, since the government is spending more than it taxes); and foreign savings is, basically, the difference between imports and exports. This means that when household savings increase (as people pay down their debts, tighten their metaphorical belts, and save for a rainy day), corporate profits will fall unless one of three things happens: 1. imports increase relative to exports (something hard to do as Europe melts down), 2. government spending relative to taxes increases (thus increasing the budget deficit), or 3. investment or dividends grow (basically, corporations saving less, the opposite of the cash hoarding we've seen lately).
Since corporate profits fuel stock-market prices, the rising stock market can be thought of as a result of our huge budget deficits. Despite all the caterwauling you hear from "pro-business" Republicans, it has been government that is behind the rise in corporate profits. This creates a risk, of course. If government deficits shrink, profits will also. Unless, of course, one of the other sources of profits grows. Fortunately for investors, that seems unlikely. As Kashkari says, one thing both parties seem to agree on in action -- although both claim to deny it in principle -- is that they like deficits. --Written by John Carney at CNBC