The Stock Market, Credit and Capital Formation

CHAPTER II

CONCEPTS USED AND PROBLEMS DISCUSSED

4. Our main task in discussing the question of stock exchange credit is to examine the assertion that “the stock exchange absorbs capital.” This contention is the chief indictment in the case against stock exchange credit. This is evident from the fact that Cassel, the leading defender of stock exchange credit, used the same words in the title of two of his articles on the subject. One of these is entitled “Does the Security Market absorb Capital?”1 and the other “Does the Stock Exchange absorb Capital?”2

It is said that the stock exchange absorbs capital.

Undoubtedly the discussion has suffered a good deal from the lack of uniformity in the use of terms. Not only did the various writers attach different meanings to certain technical terms, but also one and the same author often used the same term in vastly different senses in one and the same publication. The most obvious and most serious of these confusions is connected with the concept of capital. But even the term “stock exchange” does not always signify the same thing, and exactly what is meant by “absorption of capital” has seldom been unambiguously defined.

This contention contains ambiguous terms

With reference to this last expression it is worth noting that it may be possible to have the use of something without depriving someone else of it. Stock exchange speculation has often been held to be just such a case, to the effect that while it needs capital it does not withdraw it from other uses. However, it is apparent that the charge of “using” credit must, if it is to be an “indictment,” refer to a real “absorption,” that is to say, the withholding of capital from other uses. Now the alleged absorption may be either permanent or temporary.

What absorption means.

Disregarding the general public and certain journalistic writings, the view that permanent capital absorption took place was most emphatically advanced by Eberstadt3 and more recently by Moulton.4 Eberstadt, for instance, speaks explicitly of “capital formation for speculative purposes”5 and of accumulated capital being “sucked up” by speculation. And Moulton, likewise, believes that “money savings” or “available investment money” were “absorbed” and “dissipated”6 by the stock market boom. As against these assertions most of the proponents of the anti-stock-exchange view claimed only that there is a temporary tying up of capital by the security markets. We shall have to discuss in detail later how far this temporary absorption is possible and how far it is probable. Cassel, for example, is not ready to admit even of this temporary tying up of capital.

Some think of permanent absorption—

—others of a temporary tie-up.

5. In regard to the definition of the term “stock exchange” which is relevant here, it may be helpful to point out that we are interested for the purposes of this study in the “stock exchange as a borrower.” This might be interpreted as including all persons who use borrowed funds to acquire securities or it might mean only that narrower group of people who hold shares temporarily (usually for purposes of profiting from changes in their prices). As to that narrower group, it is not unimportant to make a distinction between speculation by professional operators and speculation by the public. Whether or not the majority of writers on speculation have had in mind only trading by professional speculators, our investigations will have to include amateur speculators, and in fact all people who have anything to do with security markets.7

Who are “the stock exchange”?—

—Stock exchange members only—

—or all buyers and sellers of securities?

6. The use of the capital concept, or, more accurately, of the capital concepts,8 has been the source of infinite confusion, a “second confusion of tongues, a second Babel.”9 “Our science cannot possibly concede the right to its students for all time to call ten or twelve fundamentally different things by the same name.” Thus wrote Böhm-Bawerk1 in 1888. How much uniformity of terminology is there now in the twentieth century? The “capital” which is “drained away” or “dissipated” is evidently something quite different from the “capital” which is “replaced” by new and more productive capital. The “capital” which “flows over” from the money market onto the capital market is again not the same thing as the “capital” which is “built up” out of borrowed credit. It would be possible to give several pages of examples of this kind. The words of Carl Menger written half a century ago are just as true to-day. “There are,” he said,2 “as many different and equally confused ideas as to what is the nature of capital as there are authors.” It is almost unbelievable that, many decades after the publication of Böhm-Bawerk’s Positive Theory, we should have to recall these words not as a historical reminiscence but as relevant to the present day.3

There is great confusion over the meaning of capital.

The inadequacy of terms has made it customary to designate the produced means of production, and the funds made available for the construction of such goods, and the funds already invested in such goods, all by the same word “capital.” The misunderstandings to which this was bound to give rise, and which have indeed had extremely unfortunate results, can only be avoided if we determine to make the multiplicity of concepts clear by giving them different names. Whether we continue to designate one of the concepts by the term “capital” pure and simple, and look for new terms for the others, or whether we merely decide to use the word capital always with a qualifying adjective, is essentially a matter of indifference so long as the majority of economists accept the new nomenclature.

One word is used for three concepts.

It is now customary to call the produced means of production “capital goods” or “real capital.” The funds available for the construction or acquisition of real capital are very conveniently described by the term “money capital.” Another concept which is somewhat broader than “money capital” is occasionally found useful, especially for a theory of a moneyless exchange economy; for some years past Cassel’s term “capital disposal” has been used in the sense of power of disposal over goods which are used for the construction or acquisition of real capital. This concept of capital disposal was adopted in a great deal of the German literature.4

Capital goods and money capital.

Böhm-Bawerk rejected the conceptual isolation of a “power of disposal” over an object from the object itself and reverted to the use of the word “capital” for describing “capital goods.” Capital goods are sometimes called “future goods” because they are the produced means of production which do not yield consumable services until some future time. The need to distinguish between the power to acquire goods for use in the capitalistic process (capital disposal or money capital) and the capital goods themselves (real capital) becomes apparent as soon as we introduce the assumptions of an exchange economy. For readers faced with the phrase “the supply of capital” cannot always be sure whether it refers to the supply of capital goods or to the supply of money capital. This is particularly awkward in discussions of the situation on the capital market, the function of which is to facilitate the exchange of money capital against titles to real capital. The more common practice at the present time is to consider the supply of “capital” not as the supply of “future goods” but as the supply of “present purchasing power” which is offered in exchange for them. Many people, however, insist on taking the opposite course, and considerable confusion has been the consequence. The German writer Schulze-Gaevernitz, for example, in his widely read monograph on the German credit market,5 says: “The market for fixed capital, such as factory buildings and machines, that is to say, the supply of fixed capital in exchange for long-term creditor rights, is what is called the capital market.” This makes it appear as though both parties in the capital market offer “future goods” in exchange—the one machines and the other securities—and the present goods (money or abstract purchasing power) fall right out of the picture. In actual fact the “long-term creditor rights” concerned, are identical with the titles to real capital or its return, and these titles are offered in exchange for money capital. Thus what takes place on the capital market is an exchange of rights in or over capital in the Böhm-Bawerkian sense (i.e., capital goods) against capital in the Menger-Cassel sense (i.e., money capital or capital disposal). It is of course immaterial which of the two parties is regarded as constituting the demand side and which the supply side: the one offers money capital in exchange for rights over real capital, and the other offers rights over real capital in exchange for money capital.

Capital disposal is distinguished from real capital.

On the capital market present purchasing power is exchanged for titles to future goods

The didactical value of the concept of capital disposal is apparent in the theory of saving and capital formation. For a long time there was much diversity of opinion as to what was the real nature of saving. It was denied that saving was the necessary condition of capital formation, because real capital was not saved but produced. It was denied that consumption goods were saved, since accumulated stocks of consumption goods were not capital. Finally, it came to be recognized that it is the services of the factors of production that are saved, but this conception is one that is rather far removed from the concretely observable phenomena of economic life. An offer of capital is not in itself an offer of productive factors. If we make use of the term “capital disposal” however, we can express the idea as follows: the saver provides the entrepreneur with capital disposal thereby giving him command over the services of productive resources of which the saver has forgone the present (or near future) enjoyment.

Saving and capital formation.

Böhm-Bawerk may have been searching for a similar term, as, for example, when he says that the community invests “what is saved,” and that, when “it” is transferred in the form of producers’ credit, it increases the purchasing power available to producers for productive purposes and finally leads to a changed “disposition” over the factors of production.6 Why, it may be asked, should not this “something,” which leads to a change in the disposal of the factors of production, simply be called “savings” or “saved funds,” thus avoiding the need for the clumsy expression “capital disposal” or even for the term “money capital”?

The proceeds of saving are money capital.

7. The concepts of capital disposal and money capital include more than savings. They include in addition the current replacement funds (amortization capital) of the economic system which are available for reinvestment. Savings previously invested in durable capital goods become free again by way of depreciation allowances, and these, as a part of the gross receipts, constitute money capital or “free capital disposal.” They do not, however, represent any increase in the total capital resources of the community. The current inflow to replacement funds represents free capital disposal available for the construction or reconstruction of real capital exactly as do the proceeds of current new savings.

Money capital is provided also by replacement allowances—

As far as producers’ goods industries are concerned, the sales-proceeds of the sellers of these producers’ goods are identical with the investment in them by the purchasers of these goods. The amortization allowances, which are a part of the sales-proceeds and which now become available to the seller for reinvestment, are thus part of the investment of the buyer. What this means, however, is simply that the release of money capital at one stage of production is counter-balanced by a tying up of money capital in the next stage. From the point of view of the economic system as a whole the money capital of the replacement fund is ultimately collected from the consumers by the sale of the final product to them. The price of the final consumable product, provided that the expectations of all the producers concerned are realized, contains the various contributions to the replacement funds of all the earlier stages of production. Thus, it is the consumer, who, in paying the price of the consumption goods, is making the replacement capital available to the producers, should the latter care to reinvest. Nonetheless, in a money economy where the various stages of production are not integrated but constitute independent financial units, where each sells to another, the replacement funds realized at each stage have to be regarded as liquid money capital.

The case is similar for so-called working capital or circulating capital. From the point of view of the economy as a whole the liquidated working capital cannot all be regarded as free capital disposal; the working capital of the producers in the intermediate stages is only “turned over,” and is made free to the individual firm to the extent that the producers in the next succeeding stage of production tie up their working capital. It is only when the whole production process has been profitably completed, and the finished product has been sold to the consumer that the capital disposal embodied in circulating capital becomes free and available for reinvestment. It is possible, though not customary, to call this a case of amortization: amortization takes place at the successful conclusion of the technical process of production to the extent of 100% for capital goods which are used up in the single process, and of smaller percentages for durable capital goods. In neither case is it possible to talk of an automatic “reproduction of capital.” It is truer to say that it depends entirely on the entrepreneurs as capitalists whether the funds which are made free by the successful conduct of their business, shall be “put back” and reinvested.

—and by turnover of working capital,—

Capital disposal or money capital is however a term which includes not only saved or resaved purchasing power, i.e., new saving and maintained saving, but also new purchasing power created by way of bank credit. This, too, gives command over the services of productive factors for the production of capital goods, and is thus capital disposal. There remains one other source of purchasing power which belongs to the same category, viz., liquid cash balances which suddenly come to be considered by their holders as excessive liquid reserves, and are consequently drawn on for the purchase of production goods and productive services. A concept of money capital which includes current savings, current replacement allowances, currently liquidated working capital, and also new bank credit and disbursements of surplus cash balances is in complete conformity with the facts of practical economic life as they appear to the ordinary observer who is otherwise unacquainted with economic theory. The inclusion of all purchasing power, which is not used for consumption purposes, irrespective of its source, brings the concept into harmony with the popular conception of money capital. The fact that “inflationary” credit is grouped under a common head along with credit granted out of voluntary savings should not however blind us to their different nature. A more detailed analysis of the alternative sources of the supply of money capital reveals marked differences in their effects on economic development.7

—and may also come from credit creation and dishoarding.

There are thus five sources of supply of money capital.

If we define money capital as sums of money which are available for the purchase of productive goods and services, and ascribe these funds to five main sources, we must be clear on the following points. In the first place it must be realized that we are using “money” in the widest sense of the term to include checking accounts at the banks. (It is commonly recognized that in the United States and England where the major part of money transactions are carried out by the way of cheque payments, new bank credit is an important source of new money capital.) Further, it is important to recognize that it is impossible to draw rigid lines between the five sources of the flow of money capital. We propose to distinguish (1) the supply of current savings, (2) the current inflow to the replacement fund, (3) the proceeds of the turnover of working capital, (4) additional purchasing power created by way of bank credit, and (5) disbursements out of surplus cash balances. The distribution of the gross receipts of a business man or of a firm between (1), (2) and (3) is somewhat arbitrary or at least a matter of subjective estimate. That part of the gross receipts which is allocated to the covering of direct costs of production and which represents liquidated working capital is not definitely determinable. This is true in so far as the direct costs, especially the prices of raw materials, are subject to fluctuations, and hidden reserves may be built up in the valuation of stocks of raw materials still on hand. This blurs the line between new savings and liquidated working capital. The part of gross receipts which is regarded as belonging to the replacement fund is still less capable of precise determination. It is only too well known that the amount of depreciation of fixed capital through wear and tear and obsolescence is purely a matter of conjecture. If the depreciation allowances are conservative the replacement fund will appear to be larger, and saving out of business profits smaller; and if less liberal allowances are made for depreciation the figure for saving out of profits will be swollen at the expense of the replacement fund. The rôle played by the valuation of assets in the process of calculating the net income of firms and individuals, and correspondingly in the calculation of the amount which is regarded as having been saved, is sufficiently familiar.8 These few remarks show that there can be no clear line of division between the supply of money capital derived respectively from the proceeds of savings, replacement funds, and liquidated working capital. In a later chapter it will also be shown that the division between these three sources of money capital on the one hand and credit expansion on the other cannot be made with the necessary clarity. We shall see that there is no simple way of dividing bank credit into a supply of current new savings and a supply of inflationary purchasing power; we shall also find that disbursements out of replacement funds and liquid working capital are often difficult to distinguish from increased disbursements out of surplus cash balances. And there are other cases where reality cannot be nicely sorted into our “boxes.”

“Money” includes bank deposits.

There are no sharp lines between new savings and liquidated working capital,—

—or between new savings and replacement allowances;—

—or between new savings and created credit;—

—or between replacement funds, working capital, and surplus cash balances.

8. Money capital, no matter what is its source, is by definition available for the production of capital goods. The concept of capital disposal, which may in many cases be used synonymously with money capital, has, however, been defined by many authors in another way which largely robs it of its usefulness. Thus Cassel, Adolf Weber and some of their pupils do not restrict the term “capital disposal” to the aggregate of the funds available for the formation or creation of real capital, but include as well the funds already invested in the existing stock of real capital. It would have been more useful if the term “capital disposal” had been applied exclusively to the free, disposable funds ready to be transformed into future goods (real capital), and had been contrasted with the funds already invested, especially since the latter are represented by already existing real capital. There is no possibility of any further “disposal” over this “capital which is invested and not available for other productive purposes”9; yet the authors of the term “capital disposal” did intend it to include these already invested funds. They may point to the fact that from the standpoint of the individual firm, every item of real capital can be reconverted into “free capital disposal,” and that for the determination of interest rates the invested as well as the free capital disposal is of importance.

One should distinguish between free capital disposal and invested capital;—

The theory of interest, however, is just where the distinction between free and invested capital disposal becomes important, since it is only free capital disposal, or, that is, money capital, which constitutes the supply side of the credit market. What is called, for short, “capital supply” on the credit market is the supply of freely disposable money which comes from the sources mentioned above: the proceeds of savings, replacement funds, liquidated working capital, surplus cash reserves and credit creation by the banks. Among the determining factors on the demand side of the credit market is the quantity of capital disposal already invested or, more accurately, the existing stock of real capital,10 because it is this which affects the expected returns of fresh investment opportunities, i.e., the marginal productivity of capital.1

—the former constitutes the supply of credit,—

—the latter affects the demand for credit.

The two capital concepts, real capital and money capital,2 are adequate for all essential purposes of economic analysis. It is fairly obvious that both capital concepts, that is, the provision of money capital and its investment in real capital, are relevant to the process of capital formation. Whenever we use the word “capital” without a qualifying adjective in our discussion, it will not be difficult to see which of the two concepts is meant. The adopted terminology will have to stand the test of its usefulness in the subsequent analysis. If the results are satisfactory, it may perhaps help towards establishing a greater degree of uniformity in the vocabulary of economists.

The term “capital” usually calls for a qualifying adjective.

9. The clear definition of concepts makes it apparent that the question whether the stock exchange absorbs capital is susceptible to a number of different interpretations. The answer must deal with various possibilities: total absorption versus temporary tie-up, of real capital versus money capital, in security speculation by professionals versus the general public.

The main questions for discussion.

It is important, however, not to lose sight of the practical purpose of the whole inquiry. The main point at issue is whether security speculation, and its demand for credit deprives other borrowers, especially industrial borrowers, of something. This “something,” which is alleged to be wasted, is usually said to be “capital.” Our investigations will not be complete with the answering of the question as it has been formulated so far. The questions which relate in the first instance to the possibility that capital may be withheld from industry may be put more broadly so as to ask whether industry does not (or does not also) suffer in other ways as the result of operations on, and borrowing by, the stock exchange. We shall therefore have to extend our inquiry to deal with the often alleged “tying up of purchasing power,” and “absorption of means of payment” by the stock exchange, and with its use of bank credit and influence upon the lending capacity of the banking system.

This, however, does not exhaust the numerous objections which have been raised against speculation in securities and lending to the stock exchange. We shall have to examine the further contentions that stock exchange speculation causes malinvestment and overinvestment, and that it is responsible for credit inflation on the one hand and dearer money on the other.

With all these sins to account for, our programme is not a small one. The purpose is neither to acquit the stock exchange of the charges brought against it nor to condemn it; nor is it our task to make recommendations of a political nature. We shall take the list of accusations simply as an approach to general problems associated with the relationships between the stock exchange, credit and capital formation. If the results of our theoretical analysis prove useful as a guide to bank policy or trade-cycle policy, so much the better.

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