The Stock Market, Credit and Capital Formation

CHAPTER III

THE ROLE OF CAPITAL IN SECURITY TRANSACTIONS

10. There is one sense in which the contention that the securities markets involve either a permanent or a temporary absorption of capital is so obviously absurd as to require no further discussion. Real capital or produced means of production, such as bricks, iron girders, machines, pulleys, cranes, &c., are neither absorbed nor tied up by security speculation.

However, even if no sense can be made of the hypothesis that security speculation absorbs real capital, it is nevertheless necessary to analyse those aspects of the formation and utilization of real capital which link up with the security market.

The relationship between security transactions and the formation of real capital is to be analysed.

11. The stock exchange is the place where securities—negotiable investment claims against assets and their periodical return—are bought and sold. So far as old securities (whether bonds, i.e., fixed interest-bearing securities, or shares, i.e., membership rights in a corporation carrying the claim to a share in the profits) are concerned, it is immaterial from the point of view of real capital formation or its utilization how many times and at what prices these existing titles to a share in the yield of real capital change hands.

The essential function of the security method of raising capital is to facilitate changes in ownership of the titles to real capital. The transfer of other types of equities and of open lines of credits, meets with obstacles which hinder any very frequent operations of this kind. But if the financial participation, or the loan, is acknowledged in some form of transferable certificate, then the exit of an old member of the company and the entry of a new one, or the repayment of one creditor and simultaneous borrowing from another, is very simply arranged through the purchase and sale of the securities.

The security market facilitates changes in ownership of titles to real capital.

We are here bringing the two forms of security, stocks and bonds, under one formula which abstracts from the legal distinctions and concentrates on the essential economic characteristics common to both. As to their periodic share in the return of the enterprise we may call both capital shares; while if we wish to emphasize the transfer of purchasing power we may regard both as credit transactions. There has been a great deal of discussion as to whether, for purposes of economic theory, a shareholder is to be regarded as an entrepreneur or a creditor.1 Both viewpoints are valid and it depends on the purpose of the investigation whether the entrepreneur function or the creditor function should be placed in the foreground. For our purposes it will usually be necessary to chose the latter. For example, a joint stock company has the choice of meeting increased capital requirements either by issuing shares or by issuing bonds. If the company in the given market situation takes the first course, we shall be wise, in treating problems of credit theory, to stress the borrowing aspect of the operation, rather than to consider the purchasers of the new shares as new entrepreneurs. Likewise, when we are analysing the case of an investor, who considers whether he should invest his liquid funds in bonds or in shares and eventually decides in favour of the latter, we should not hesitate to class this purchase of shares as a loan operation from the point of view of our analysis of the credit market.

Shares and bonds—

—both may be treated as instruments in credit transactions.

The chief advantage of the security method of lending and borrowing is that the credit obtained through the issue of securities is a long-term one for the borrower (in the case of shares, it runs for the entire life of the business enterprise) while from the point of view of the capitalist it is not a long-term loan at all, and has in fact no definite term. If the capitalist should at any time need the funds, which he transferred to the corporation, he can get them back by selling his security. As a rule, this withdrawal of the “loan” has no effect on the corporation, because one capitalist’s place is taken by another, the new purchaser of the share; and the capitalist who wants to realize his securities will be able to do so without loss provided he has exercised the necessary care in choosing his investment and the security market is sufficiently active.

The security method of transferring capital:—

—short-term for the “lender,”—

—long-term for the “borrower.”

12. Professional security speculation creates what may be called a reservoir for the easy equalization of supply and demand at any moment of time, so as to prevent wide fluctuations in security prices due to fortuitous circumstances. Without this “reservoir for stray securities” it is unlikely that all shareholders who wanted to realize their securities would be able to find investors who were willing to buy them just at the right moment. An offer for sale of securities for which there were no immediate buyers would cause a fall in prices, and shareholders who were obliged to sell on a weak market would recover much less than the full amount of the money capital which they had placed at the disposal of the corporation when they purchased their shares. This loss to capitalists would not of course represent a loss to society, since the business enterprise, and the real capital belonging to it, would remain unaffected throughout the transaction, unaffected by the change in ownership of the shares. The loss of the capitalists who sold at a low price would be balanced by the gain of the buyers who bought so cheaply. Owners of capital funds would, however, lose confidence in the possibility of being able at all times to sell securities without loss, and without this confidence there could be no “security capitalism”2; there would not be the same full utilization of the smallest amounts of capital, and savings which were not intended to be of a long-term character would remain idle as the saver would wish to keep them in a form in which they would be available for use at all times. Thus there would not be the same quantity of capital invested in industry as is possible through the institution of the security form of finance, and the active security market that goes with it.3

Effective speculation makes securities more liquid—

—and encourages investment of temporary savings.

The function of the professional security speculator, or jobber (specialist), consists in this widening of the market which gives it the capacity both for taking up a sudden offer of securities for sale and for satisfying a sudden demand for securities. It is only the existence of professional security speculation that can prevent price fluctuations which are unrelated to judgments as to the yield and safety of the security. Moreover, the professional speculator’s carrying capacity is of importance in providing a fluid market not merely for the realization of old securities but also for the issue of new ones. These security issues are held by professional speculators until they are purchased by more permanent holders; only gradually will the stray securities be taken out of the reservoir provided by the speculators and absorbed in the channels provided by the savings of the public.

Professional speculation provides a market for stray securities.

13. While, as has been indicated above, the mere change of ownership of existing securities, whether between genuine investors or between speculators, has little or nothing to do with the formation or utilization of real capital, the issue of new securities may mean the allocation of new money capital to industry. We say “may” because there are cases of issues made by investment trusts which use the proceeds to purchase already existing shares, so that the transaction represents a mere change of ownership. Or it may happen that the issue is nothing more than an operation for the conversion or funding of a previous loan or credit, in which case it is again not relevant to the formation of real capital. An industrial enterprise may have financed an extension of its plant provisionally by means of overdrafts and open book accounts. When it later funds its debts by increasing its capital stock (issue of securities), this second transaction has no impact on the sphere of real capital. All that takes place is a change in the person of the creditor: the first lender has his money capital returned to him and the subscriber to the new issue puts in his. The fact that the money capital which is released flows back to the “money market,” and that the newly invested money, on the other hand, comes from the “capital market,” is a technicality which does not concern us in the present context.

New security issues may mean allocation of new money capital to industry.

This is not true for new shares of investment trusts or for refunding operations.

14. Let us now follow the chain of economic events which lead to the formation and installation of real capital.

Capital formation arises out of the application to productive purposes of that part of income which is saved. The refraining of an individual from consuming part of his income does not of itself lead to capital formation. If there is to be capital formation, the postponement of consumption (“waiting,” or foregoing of present goods) needs to be supplemented by the creation of means of production (“investment,” or production of future goods). In a money economy, when an individual refrains from using part of his money income as present purchasing power and saves it by putting it aside in a stocking or a money box, or by leaving it idle on current account at his bank, capital formation fails to take place, and saving by the individual does not give rise to saving from the point of view of society as a whole. The withdrawal of means of payment from the market, as the result of hoarding, tends to augment the purchasing power of the whole of the rest of money income. If the money prices of productive factors were sufficiently flexible, the income given us by the saver would accrue to other people in the form of a corresponding increase in their real income. There would thus be no restriction of the total consumption of present goods and no extension of the production of future goods, unless it were to the extent that the deflation raised (through lower prices) the purchasing power of investors as well as that of consumers. The reduction of consumption by the saver leads, when it is not accompanied by corresponding investment, and when factor prices are rigid, to a curtailment of production and to unemployment. This theme has received sufficient emphasis in recent years as not to require further mention here.

Saving alone is not sufficient for capital formation: it requires investment also.

A process of capital formation is set in motion only if the income which is not consumed is used for production. It does not matter whether the saver is himself the entrepreneur or whether he places his purchasing power or money capital at the disposal of another entrepreneur. The process of transferring savings to the producers may be performed through the borrowing and lending facilities of the savings banks, but mainly through the capital market which centres around the securities market. Which one of these organizations for transferring savings will be used will depend in each case on judgments as to risk and liquidity (the possibility of withdrawal or realization by selling) and prospects as to yields. If the savings are put into savings bank deposits, the yield will be equivalent to the interest payment. If they are used to purchase fixed interest-bearing securities (mortgage loans, bonds, debentures) the yield will take the form of interest and capital appreciation. If they are used to purchase shares, the yield will consist of dividends and capital appreciation. The relative attractiveness of savings deposits, the bond market and the stock market, changes with the different phases of the trade cycle. From time to time various economic reasons, usually depending on the experiences in the immediately preceding period, are also advanced for preferring, from the point of view of “society,” one way of using savings to another.

Ways of transferring savings to producers.

15. By way of continuing our analysis we may suppose that the money finds its way to an industrial firm through the purchase of newly issued shares of this firm by the saver. We may take the case of a firm which plans to extend its power plant by building a new water dam. The money capital of the saver will then be used by the investor for the creation of real capital in the form of a dam.

Money capital may be used for the formation of real capital—

We purposely chose the example of a dam because that is a clear case of a formation of new real capital. The case is different if the firm buys machines which have previously been held in stock by the manufacturer in the expectation (justified by past experience) of a forthcoming demand for them. In that instance, the real capital already exists, and the money capital transferred to the firm in question is merely used to buy already produced real capital. But what was the source of the funds which made the production of this capital good possible? The stock of machines ready for sale is a part of the circulating capital of the machine factory. No matter whether the machine factory obtained its circulating capital from the money market or whether it took it from its own resources, money capital from somewhere must have been used in the production of the machine. This part of the machine factory’s circulating capital is now turned over, i.e., the factory gets back the money capital embodied in the inventory by selling the machine. What makes it possible in our example for the machine factory to recover this circulating capital in liquid form? It is made possible by the fact that the purchaser of the shares puts money capital at the disposal of the firm buying the machine.

—or for the purchase of already produced capital goods;—

—in this case it liquidates circulating capital tied up by the producers of the capital goods.

In this example we illustrated the taking over of already produced real capital from the stocks of finished goods of the machine factory. The same kind of thing takes place in part when the machines are produced to order. This is true for the following reason: whether the machine factory already has the necessary materials in its own stocks of raw materials, or whether it has to obtain them from the stocks of finished goods ready for sale at the iron foundries, &c., these materials were already, in large part at least, previously produced real capital. They represented previous investment of circulating capital by the firms concerned. Thus the production of machines constitutes in part the employment of real capital already in existence and in part the formation of new real capital; the former to the extent to which materials previously produced are taken over and equipment previously installed is used up; the latter to the extent to which services are added in the production of the machines.4

Many cases combine formation of new capital with liquidation of old capital.

16. Thus far we have acquainted ourselves with a number of cases in each of which the firm raises its money capital by way of an issue of shares but with different effects in the sphere of real capital.

In one case the newly raised money capital was used to repay a bank loan. Here the real capital had obviously been produced previously by means of the bank loan, and the new money capital (derived from the issue of shares) merely took the place of what was paid back to the first lender whose funds then became free again for new lending.

Different uses of the new money capital raised by corporations are reviewed.

In the second case the new money capital was used to build a dam, and here the new money capital clearly led to the formation of new real capital.

In the third case, the new money capital was used to procure finished machines from inventory stocks. This implied the taking over of already produced real capital with the result that the money capital previously invested in the latter was released for use elsewhere. A fourth case was a combination of the second and third cases.

Mention may also be made of a further case where the new money capital is intended for the production of new real capital, but instead of being invested immediately after it is subscribed, it is invested only gradually as the work of construction proceeds. The money capital which is not required until later may be supposed to be lent to the money market on short term5 until the date when it is required.

The foregoing examples showed that where new money capital was absorbed (i.e., tied up without release for use elsewhere) there was formation of new real capital; where there was no real capital formation, there was no absorption of money capital. The mere exchange of money capital did not involve absorption, since, the moment the new funds were invested, the previously invested funds were released. Nevertheless there may be some doubt whether there is not a delay before the released funds are utilized again. But a delay in making use of money capital will be penalized by loss of interest, and every private individual, more especially every business firm, tries to avoid this whenever possible. In any case the problem of delays occurring in the utilization of purchasing power when it is transferred is a subject which will be dealt with in detail in subsequent chapters.

Money capital is absorbed where real capital is produced.

So far, we have been concerned with the case of the absorption of money capital in the purchase of newly issued shares. We have still to consider the possibility of the absorption or tying up of money capital by transactions in old securities.

17. It was Cassel who once made the statement6 that “a reproducible durable good can exercise a demand for capital disposal once only, and the extent of this demand is equivalent to the costs of production of the good.” Capital goods, then, require money capital once, i.e., when they are produced. When they are exchanged, or when the shares representing titles to them are exchanged, they require no additional money capital.

Do transactions in old securities tie up money capital?

However, a purchaser of shares (who buys on a speculative market when stock prices are rising) often has to pay a larger amount of money capital than was required at the time of the production of the real capital behind the securities. Does not this experience contradict what was said above? The contradiction is apparent only, as may be seen when one realizes that the larger amount of money capital which is invested by the purchaser of the shares becomes free simultaneously in the hands of the seller of the shares. Let us suppose that capitalist A originally purchased shares at the price of $100 and that the issuing firm produced real capital for this $100. Now at a time when security prices are booming, capitalist B offers A a price of $120 for the same shares and uses his savings to buy them. What is the amount of money capital which is now tied up; is it $100 or $120 or $220?7 The simple consideration that the $120 paid by B is at the free disposal of A at the conclusion of the transaction should indicate that, in spite of the speculative purchase at the price of $120, the amount of money capital tied up is still only the original $100.

This rather simple judgment, however, meets with serious objections which are not without justification. With his customary self-confidence, Cassel, who was quoted above in this connexion, completely ignored this issue so that there is all the more reason why we should examine it here. First, however, let us elaborate upon the example used above to illustrate another important charge which is brought against security speculation.

18. Granted that the seller (A) of the shares has the $120 at his disposal as the result of the sale, will he not treat the profit of $20 as income, and consume it? Does not the rise in security prices lead to the consumption of the amount of capital appreciation of the shares and thus cause an “absorption,” namely, the consumption of a large part of the new savings? If A who sells the shares reinvests $100 (that is, the amount of savings invested by him in the first place) but consumes his gain of $20, then $20 out of the $120 newly saved by B is withheld from real investment and used for consumption purposes.

Consumption of stock exchange profits is at the expense of capital formation.

The possibility that capital may be diverted into consumption channels through the consumption of profits is usually looked upon as being peculiar to security speculation. If any producer, let us say a manufacturer of machines, uses his profits for consumption purposes, this does not usually evoke the protest that capital is being taken away from its proper uses. And yet this profit is nothing other than the difference between the money capital obtained from the sale of the machines and the money capital used in their actual production. If an industrial firm uses the funds it has borrowed to purchase machines for $120 from a manufacturer who produced them at a cost of $100, then the consumption of his profits by the machine manufacturer uses up $20 of new savings.

All consumption of profits—apart from those in consumers’ goods industries—may be said to be at the expense of capital formation no matter in what stage of production the profits arise. It may be that there is a particularly strong tendency among security speculators to consume their profits, although it is difficult to find conclusive evidence that this is so.

It is said that profits from speculation are more likely to be consumed than other profits.

19. The question may now be asked: Is it not possible that the sellers of shares may consume the whole of the sales proceeds? Certainly they may, and indeed it very frequently happens that shares are sold by their holders for the express purpose of using the proceeds for consumption purposes. It must not be forgotten that not only permanent, but also temporary short-term savings, are invested in shares. Indeed, as has been pointed out in an earlier paragraph, it is the main advantage of the security system of financing real capital that it allows temporary savings put by for future requirements (that is, temporarily postponed consumption) to be used for the formation of fixed capital. This procedure necessarily implies that “temporary savers” will withdraw their savings in order to use them for consumption.

Temporary savings are used for financing real capital formation—

—and later withdrawn for consumption.

Admittedly such withdrawals of capital on a large scale may have adverse effects on production, possibly preventing the maintenance of production at the current level, but this is less likely to happen under the system of financing through securities than under any other system. Even if it should happen at any time that savings of a temporary character are withdrawn (for previously postponed consumption) in excess of new temporary savings invested by other individuals, it will seldom be the case that the sum of the new temporary savings plus the sum of the new permanent savings will be exceeded. It may be necessary to use new long-term savings to cover withdrawals of other savings; but the fact that in this case the new money capital does not lead to the production of new real capital means only that the real capital was produced in advance, i.e., before the long-term savings were offered on the market.

Such withdrawal is financed by new savings—

If, however, the withdrawals by “temporary savers” should not be covered by new short-term and long-term savings together there remains the buying power of professional speculators to fall back on. If even this is not sufficient (in practice a large part of temporary savings are used to finance security speculation), then, as was mentioned in section 12, the deficit still does not take effect on the side of real capital: the losses of the shareholders who sell out simply mean that the latter have so much less to consume. The money capital which was originally invested in real capital will remain fixed in this real capital until it is fully amortized.8

—the original investment still stands.

20. Security holdings are sometimes realized, not because the owner wishes to use the proceeds for consumption purposes, but because he wants to invest his money capital somewhere else. It is a widespread practice for firms to invest liquid funds for a temporary period in securities (either of other undertakings or of their own) and later to withdraw them, by the sale of these securities, when it becomes more profitable to use the money capital in their own businesses. If the securities are taken over by new savers, the newly saved money capital may thus flow into industry despite the fact that no new shares are issued and that the new savings are used first to buy old securities.

The proceeds from selling old securities also may be used for investment in real capital.

The flow of money capital to the securities market can thus lead to the formation of new real capital, even if there are no new security issues, so long as the seller of the old securities uses the proceeds for real investment. If the transaction causes a rise in the price of the security, then the seller has so much more money capital available for “productive” investment.

21. Support is lent to the argument that security speculation ties up capital by the consideration that the speculators, particularly the professional speculators (jobbers and dealers) need money capital with which to carry out their operations. In examining the rôle of money capital which is “tied up by speculation,” we may refer back to the observations concerning the function of professional security speculation made in an earlier section. According to these observations, it is the function of the professional speculator always to be ready to take up securities when no investor is immediately at hand. So far as newly issued shares are concerned, it is clear that the money capital of the speculators is invested in the newly built capital goods of the issuing corporation. So long as the speculative market has to “hold the baby,” as the jargon of the market expresses it, when a new issue is not immediately taken up by the public, the money capital that is “tied up in speculation” is no doubt tied up in production.

Money capital may be used by speculators—

—for carrying new securities temporarily—

What productive service is performed by the money capital which is used for speculation in old securities? The service performed is filling the gap which is created when money capital is being withdrawn by one saver and no other saver is ready at the moment to take his place. The speculator jumps into the breach and takes over the title to capital goods9 for a temporary period with his own money capital.

—and for carrying old securities—

The funds used by the speculators take the place of the money capital of the previous holders of the shares and they are invested in capital goods and therefore in production.1

When someone stands ready to provide a service in case of need, he is attached to the place without always having real work to do. He is merely “standing by.” This does not mean, of course, that this is the only function of speculative funds and that they do not also have a part to play in the productive process.

—and for “standing by.”

If the service of “standing by” is recognized as being useful, no objection could be raised even if it did tie up money capital. But it cannot be shown that it does so. The professional speculator seldom keeps large funds on hand without using them since it usually does not pay to do so. The funds owned by the speculators are almost always invested. They borrow from the outside to the extent that they require funds for paying the sellers for the additional securities which they buy.2

22. Against all this it has been contended that money capital may be tied up without being either invested in fixed capital or simultaneously released somewhere else. Before going into the arguments on this issue, however, it will be useful to summarize the results so far reached.

Assuming that a speculator has obtained money capital either direct from the saver or from a bank, there are the following alternative ways of using it: —

The alternative ways of using the speculator’s money capital are summarized.

(1) The speculator buys newly issued shares. The issuing corporation uses the proceeds to repay a bank loan. The money capital is thus once again at the free disposal of the original lender.

(2) The speculator buys newly issued shares. The issuing corporation uses the proceeds at a later date or gradually over a period for extending its plant; in the meantime it relends the proceeds at short term on the money market. The money capital is at the free disposal of the short-term borrower.

(3) The speculator buys newly issued shares. The issuing corporation uses the proceeds to buy already produced instruments of production, or to produce or purchase capital goods whose manufacture involves for the most part the utilization of already existing capital. In this case the money capital serves to take over or employ already produced real capital. The money capital is thus at the free disposal of the producer of the capital goods.

(4) The speculator buys newly issued shares. The issuing corporation uses the proceeds to produce capital goods, which are produced in the main without the employment of already existing real capital. In this case, the money capital serves to construct new real capital.3

(5) The speculator buys newly issued shares. The issuing corporation uses the proceeds for the purchase of other securities. This may be the case of a producer who buys the shares as a temporary investment, or the case of an investment trust whose regular business consists in investing in securities. If the securities acquired by the concern are newly issued shares, cases (1-5) become relevant and if they are old shares, cases (6-10).

(6) The speculator buys old shares. The seller uses the proceeds to repay a loan. The money capital is thus at the free disposal of the original lender.

(7) The speculator buys old shares. The seller uses the proceeds to make a loan. The money capital is put at the free disposal of the borrower.

(8) The speculator buys old shares. The seller uses the proceeds in production as in case (3). The money capital serves to take over or employ already produced capital goods. It is thus placed at the free disposal of the producer of the capital goods.

(9) The speculator buys old shares. The seller uses the proceeds in production as in case (4). The money capital serves to produce new real capital.

(10) The speculator buys old shares. The seller uses the proceeds for consumption purposes. Here the money capital serves simply to replace temporary savings withdrawn for consumption.

In cases (3) and (8), in (4) and (9), and in (10), the money capital is used for the purchase of goods or services. In the first four of these cases it is used for the purchase of productive goods and services, and in the last case, (10), for the purchase of consumption goods and services. In so far as these consumption goods, in case (10), are sold out of stocks, the money capital is transferred, as in cases (3) and (8), to the sellers of these stocks. Where “original” services are purchased, the money capital becomes the money income of the productive factors, and this purchasing power loses, for the time being, its character of capital. If we neglect “dissaved” amounts which are used to purchase consumption services, we may say that cases (4) and (9) are the only ones where money capital is “absorbed,” for it is only here that the purchasing power ceases to be money capital when it comes into the hands of the recipients. These are the cases where the money capital is used to create new real capital.

The money capital is either used in the production of real capital—

In all other cases the money capital is at the free disposal of its recipients, first, in the hands of the seller of the shares, and, subsequently, in cases (1) and (6) (loan repayments) in the hands of the previous lender, in cases (2) and (7) (new lending) in those of the borrowers, in cases (3) and (8) (purchase of existing real capital) in those of the producers, and in case (10) (purchase of finished consumption goods) in those of the retailer. In all these cases the money capital remains “unabsorbed” and simply changes hands, finally becoming “absorbed” when it is used for the creation of real capital. In all cases, furthermore, money capital was used in ways in which it could have been used also had it been transferred not through stock purchases but through any other form of credit transaction.

—or it is still at somebody’s free disposal.

It is of course possible that the seller of the shares, or the lender who (in cases (1) and (6)) has his loan repaid, or the producers who (in cases (3) and (8)) sell their stocks, may not want to spend the money capital which they receive, but want to keep it liquid. These would be cases of an increased desire to hold cash, usually described as increased hoarding, but they are not specifically connected with a universal speculative boom.4

However, it may be hoarded—

The money capital which is transferred by way of stock transactions may, however, be used again to make a loan to the stock exchange or to purchase other securities. It is to these possibilities that we now turn our attention.

—or used for repeated stock exchange transactions.

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