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9. Joint-Stock Companies and the Producers’ Loan Market
We are now ready to embark on an analysis of the effect of joint-stock companies on the producers’ loan market.
Let us take the aforementioned firm with a total capital stock and capital value of 130 ounces and owned by six stockholders. The firm earns a net income of 5 percent per year for its owners, and this is the interest rate earned by all the firms in the economy.
We have already seen how the firm expanded its capital by 30 ounces through the sale of new capital stock to F. Let us see what happens when a productive loan is made. Suppose that the firm borrows 20 ounces from the producers’ loan market for a five-year period. What has happened? The firm has exchanged a future good—a promise to pay money in the future—for present money. The present money has been supplied by a saver, G. It is clear that G has done the saving and is the capitalist in this transaction, while the joint stockholders A–F are here supplying future goods; and further, it is the stockholders who invest the new capital in the production system. On the surface, this seems to be a positive case of the separation of savings and investment.
However, let us look at the transaction further. G has supplied new capital, worth 20 ounces, to the firm, for a five-year period. The owners A–F take this new capital and invest it in future goods, i.e., factors of production. In other words, to the extent of 20 ounces, A–F are intermediary investors of the savings of the creditors. What will the rate of interest on this loan be? It is obvious that this rate of interest in the ERE, will be equal to 5 percent, i.e., it will be purely dependent on the rate of interest return that prevails in the price spreads of the production structure. The reason for this should be clear. We have already seen how the interest rate is determined in the production structure; we have assumed it to be 5 percent everywhere. Now, suppose that the firm offers to pay G 3 percent on the loan. Clearly, G will not lend the firm 20 ounces for a 3-percent return when he could get 5 percent as a stockholder either in the same firm or in any other firm. On the other hand, the firm is in no position to pay G any more than 5 percent, since its net return on the investment will be only 5 percent. If the maximum that the firm can pay in interest is 5 percent, and the minimum that the creditor can accept is 5 percent, it is obvious that the transaction will take place at 5 percent.
It is clear that, in essence, G, the creditor on the prospective loan market, is no different from F, the man who has invested in stock. Both have saved money instead of spending it on consumption, and both wish to sell their saved capital in exchange for future goods and to earn interest. The time-preference schedules of both F and G, as well as of everyone else, are aggregated on the time market to arrive at the rate of interest; both F and G are net savers at the market rate. The interest rate, then, is determined by the various time-preference schedules, and the final rate is set by the saving schedules, on the one hand, and by the demand-for-present-goods schedules, on the other. The demand schedules consist (and consist only) of the productive demand by laborers and landowners and the consumption demand by borrowing consumers. F and G are both net savers, interested in investing their capital for the highest return. There is no essential difference between F's method of investing his capital and G's method of investing his; the difference between investing in stock and lending money to firms is mainly a technical one. The separation between saving and investment that occurs in the latter case is completely unimportant. The interest return on investment, as set by total savings and total demands by owners of factors, completely determines the rate of interest on the producers’ loan market as well as the rate of earning on stock. The producers’ loan market is totally unimportant from the point of view of fundamental analysis; it is even useless to try to construct demand and supply schedules for this market, since its price is determined elsewhere.35 Whether saved capital is channeled into investments via stocks or via loans is unimportant. The only difference is in the legal technicalities. Indeed, even the legal difference between the creditor and the owner is a negligible one. G's loan has increased the capital value of the assets in the firm from 130 to 150. The invested 150 pays 5 percent, or 7.5 ounces per year. Let us examine the situation and see who the actual owners of this capital are (see Figure 53).
In this diagram, the left-hand rectangle represents assets at any one point in time. We see in the right-hand rectangle that 130 ounces of these assets is represented by owners’ capital, and 20 by liabilities—i.e., by I.O.U.'s due to creditors. But what does this “representation” mean?
It means that if, for example, the firm were to liquidate and go out of business, 20 ounces of its assets would be used to pay off the creditors, and 130 would go to the legal owners. It means, further, that of the seven and a half ounces paid out as net earnings per year, six and a half ounces go to the legal owners and one ounce to the creditors, each being 5 percent of their saving. In fact, each group gets 5 percent on its investment, for are not the creditors just as much investors as the stockholders? In fact, are not the creditors the owners of 20 ounces’ worth of the firm's assets, and do they not own the pro rata earnings of those 20 ounces? What functions of ownership do the creditors not have as compared to the stockholders? Even from the legal point of view, the creditors get first claim on the assets of a corporation, and they get paid before the stockholders. They are therefore definitely owners of these assets. It might be stated that since they are not shareholders, they do not vote on the decisions of the corporation, but there are many situations in which joint-stock companies issue nonvoting shares, the holders of which do not vote on company affairs, even though they receive their prorata value of the earnings.
We must conclude that economically and even in basic law, there is no difference between shareholders and productive creditors; both are equally suppliers of capital, both receive interest return as determined on the general time market, both own their proportionate share of the company's assets. The differences between the two are only technical and semantic. It is true that our discussion has so far applied only to the evenly rotating economy, but we shall see that the real world of uncertainty and entrepreneurship, while complicating matters, does not change the essentials of our analysis.36
In recent writings there has been a growing acknowledgment of the essential identity between shareholders and creditors, in contrast to the old tradition that postulated a sharp cleavage between them. But it is curious that the new literature interprets the identity in precisely the wrong way: instead of treating the creditors like shareholder-owners, it treats the shareholders like creditors. In other words, the correct approach is to consider creditors as actually part owners of the firm; but the new literature treats stockholders as merely creditors of the firm, in keeping with the new tradition of picturing the hired managers as its real controllers and owners. Managers are depicted as somehow owning the firm and paying out interest to creditors, as well as dividends to stockholders, just as any factor payment is made—as a grudging cost of production. In reality, the managers are only the hired agents of the stockholders, and it is the latter who decide how much of their earnings to reinvest in the firm and how much to “take out of the firm” in the form of “dividends.”
The commonly made distinction between “dividends” and “retained earnings” is not a useful one for the purposes of economic analysis. Retained earnings are not necessarily reinvested; they may be held out of investment in a cash balance and later paid out as dividends. Dividends, on the other hand, are not necessarily spent on consumption; they may be invested in some other firm. Therefore, this distinction is a misleading one. Earnings are either reinvested or they are not; and all corporate earnings constitute earnings of the individual owners.
Savings may be channeled through intermediaries before entering the actual producers’ loan (or the consumers’ loan) market. Finding a productive investment is one of the tasks of entrepreneurs, and it is often far more convenient for all concerned when the individual, instead of making up his mind himself on the proper channels of investment, lends or invests his money in other institutions specially set up to be experts in investment. These institutions may serve as channels, gathering in the small savings of isolated individuals, whose investments by themselves are too small to be worth the cost of finding a market for them. The institutions then invest the funds knowledgeably in larger lump sums. A typical example is the investment trust, which sells its own stock to individuals and then uses this capital to buy stock of other companies. In the ERE, the interest that will be earned from individuals’ savings via intermediaries will equal the interest earned from direct investments minus the cost of the intermediary's service, this price to be determined on the market just like other prices. Thus, if the interest rate throughout the market is 5 percent, and the cost of intermediary service is 1 percent, then, in the ERE, those who channel their savings via the convenient intermediary method will receive a 4-percent interest return on the investment of their savings.
We have thus seen the unimportance of the producers’ loan market as an independent determining factor in the establishment of the market rate of interest or in the productive system.
In many cases it is convenient to designate by different terms the rate of interest on contractual loan markets and the rate of interest in the form of earnings on investments as a result of price spreads. The former we may call the contractual rate of interest (where the interest is fixed at the time of making the contract), and the latter the natural rate of interest (i.e., the interest comes “naturally” via investments in production processes, rather than being officially included in an exchange contract). The two interest rates will, of course, coincide in the ERE.
Throughout our analysis we have been making one underlying assumption that might be modified: that individuals will always try to obtain the highest interest return. It is on this basis that we have traced the arbitrage actions and eventual uniformities of the ERE. We have assumed that each investor will try to earn as much as he can from his investment. This might not always be true, and critics of economics have never tired of reproaching economists for neglecting other than monetary ends. Economics does not neglect such ends, however. In fact, praxeological analysis explicitly includes them. As we have repeatedly pointed out, each individual attempts to maximize his psychic income, and this will translate itself into maximizing his monetary income only if other psychic ends are neutral. The ease with which economics can accommodate nonmonetary ends may readily be seen. Suppose that the interest rate in the society is 5 percent. Suppose, however, that there is a line of production that is distasteful to a large number of people, including investors. In a society, for example, where the making of arms is held in disfavor, simple arbitrage would not work to equate returns in the armament industry with those in other industries. We are not here referring to the displeasure of consumers of arms, which would, of course, reflect itself in a lowered demand for the product. We are referring to the particular displeasure of producers, specifically investors. Because of this psychic dislike, investors will require a higher return in the armament industry than in other industries. It is possible, for example, that they might require an interest return of 10 percent in the armament industry, even though the general rate of interest is 5 percent. What factors, then, will have to pay for this increased discount? We are not overly anticipating the results of our subsequent analysis if we state that the owners of nonspecific factors, i.e., those factors which can be employed elsewhere (or, strictly, the services of which can thus be employed) will certainly not accept a lower monetary return in the armament industry than in the other industries. In the ERE, their prices as determined in this industry will, then, be the same as in the other industries. In fact, they might be even higher, if the owners share the investors’ specific antipathy toward engaging in the armament industry. The burden of the lower prices at each stage of production, then, falls on the purely specific factors in the industry, those which must be devoted to this industry if they are to be in the production system at all. In the long run of the ERE, these will not be capital goods, since capital goods always need to be reproduced, and the equivalent resources can gradually or rapidly leave the industry, depending in each case on the durability of the capital good and the length of the process of its production. The specific factor may be labor, but this is not empirically likely, since labor is almost always a nonspecific factor that may shift to several occupations. It is therefore likely to be specific land factors that bear the brunt of the lower return.
The opposite will occur in the case of an industry that most investors specifically are very eager to engage in for one reason or another. In that case, they will accept a lower interest return in this production process than in others. The force of competition on the market will, once again, keep nonspecific factors at the same price from industry to industry, although the price might be lower if the factor-owners were also particularly eager to work in this industry. The higher prices at the various stages are therefore reaped by the owners of specific factors, generally land factors.
The rate of interest, then, always tends toward equality throughout its various submarkets and in its various forms. In the ERE, the rates will be uniformly equal throughout. This conclusion must be modified, however, to state that the rates of interest will differ in accordance with a “psychic” component, either positive or negative, depending on whether there is an acute dislike or liking among investors for a particular production process.37 We may say that, in the case of a particular liking, the investors are “consuming” the enjoyment of investing in the particular process and paying the price of a lower return; in the case of a particular dislike, they are charging more for a particular disutility. It must be emphasized, however, that these differences in return do not occur if merely one person particularly likes or dislikes a certain field, but only if there is a significant aggregate of strong preferences in one direction or another. This type of consumption, positive or negative, is intertwined in the production process and occurs directly with production, and thus differs from ordinary consumption, which occurs at the end of the production process.
- 35. As Frank Fetter brilliantly stated:
Contract [interest] is based on and tends to conform to economic interest [i.e., the “natural interest” price differential between stages]. ... It is economic interest that we seek to explain logically through the economic nature of the goods. Contract interest is a secondary problem—a business and legal problem—as to who shall have the benefit of the income arising with the possession of the goods. It is closely connected with the question of ownership. (Fetter, “Recent Discussions of the Capital Concept,” pp. 24–25)
- 36. “The creditor is always a virtual partner of the debtor or a virtual owner of the pledged and mortgaged property.” Mises, Human Action, p. 536. Also see Fetter, “Recent Discussions of the Capital Concept,” p. 432.
- 37. Similar psychic components may occur in the consumers’ loan market—for example, if there is general strong liking or dislike for a certain borrower.