The Stock Market, Credit and Capital Formation

CHAPTER IV

THE ABSORPTION OF CAPITAL IN STOCK EXCHANGE SPECULATION

23. What does it really mean to say that money capital is absorbed in unproductive uses? By definition money capital is purchasing power which, not being used for present consumption, is available for the production of future goods or, that is, of capital goods. The foregoing of present consumption would make it possible to increase the productive yield of the future. It seems to be a recognized objective of economic policy that such productive opportunities should be utilized, for otherwise so much productive energy is lost to future production. But this is exactly what would happen if money capital were “absorbed” before it could be invested in productive enterprise. The case of such “absorption” is analogous to the case of hoarding.

Unproductive absorption of money capital would involve a loss of potential energy to production.

It was mentioned previously that saving by the individual does not necessarily lead to saving from the point of view of society; such is the case when the individual forgoes the consumption of part of his income but does not put it to any productive use. When the individual hoards—saves without investing—he loses the interest which would have been yielded by an investment. We have then to ask whether the loss to society is identical with the loss of interest on the part of the individual who hoards his savings. As a first approximation it might be argued that the net product of the more roundabout methods of production, which are made possible by the investment of money capital, is imputed, and paid, to the saver in the form of interest, and therefore that the loss of social net product is already allowed for in the loss suffered by the individual saver; that it would thus be double counting to consider the loss to society as something over and above this. This conclusion overlooks the point that the marginal productivity of other factors, as well as that of capital, has to be considered. An increase in capital equipment is associated with a decline in the marginal productivity of capital and a rise in the marginal productivity of labour. The fact that this shift in the distribution of the national income fails to take place if savings are not invested has to be taken into account in addition to the loss of interest.

An individual saver who does not invest loses potential income.

Is the loss from hoarding to society identical with the interest lost to the hoarder ?

Marginal productivity theory shows that the loss to society is slightly greater.

These considerations belong to the “pure theory of distribution,” and completely neglect certain propositions that have been established by “monetary theory”; it is, however, becoming more and more evident that it is not permissible to disregard the “monetary aspects.”1 The loss which society suffers when money capital is not used, or when it is unproductively “absorbed,” goes far beyond the loss of interest, because of the deflationary effects. Even with ideal flexibility of all prices, including wages, the deflationary effect would spread over the various branches of the economic system only gradually, and the various “lags” would have a chain of disturbing effects. When prices and wages are less flexible, and even rigid, the deflationary effect may entail long-lasting unemployment. It is no wonder that in times when wage rates are very “sticky” every potential deflationary influence is examined with almost painful precision.

Monetary theory points to further losses through the deflationary effects of hoarding.

24. So far we have admitted the absorption of money capital only where this absorption was “productive,” or that is, where it led to new real capital formation. In all other cases we argued that there was only a transfer of funds from one person to another. If A, who is speculating for a rise, buys shares from B, then exactly the amount of money capital that is given up by A is placed at the free disposal of B at the conclusion of the transaction.

Is there absorption if B receives what A pays ?

We must now make sure that the argument is not invalidated by the “neglect of the time element.” Economic theory abstracts from the passage of time on purely didactical grounds but frequently commits the error of failing to recognize that such an abstraction is not permissible in the final stages of the analysis. The argument so far developed has abstracted from the time element in two respects. First, it overlooked the circumstance that the mechanism of payment requires time, and that between the transfer of funds from the buyer of securities to the seller and the further utilization of their corresponding purchasing power, a certain time elapses during which the money capital may be regarded as tied up. Secondly, it neglected to consider that, in times of heavy speculation, the sellers of shares may use the proceeds to purchase other securities; that thus a long interval may elapse before the series of transactions of this kind is finally terminated by a seller who turns the proceeds of his sale into productive channels instead of using them for further security transactions.

The time element requires examination;—

—the delay of B’s disbursement after A’s payment may be considerable;—

—a delay may be caused by use of funds in continually repeated speculation.

The first point is more a question of monetary theory, since it concerns the general aspects of the tying-up of purchasing power or media of exchange. This side of the problem will come up for discussion later on (Chapters VI and VIII), and here we need only anticipate the conclusion by indicating that it does not lend much support to the “absorption” argument. The second point will be discussed at once.

25. The contention is that at certain times the seller of shares re-employs the proceeds “for a speculative purchase of other securities which he now considers to hold out better prospects of speculative gains”;2 and that through a long chain of similar transactions the money capital is continually locked up in security speculation without being “used anywhere else in the economic process.”3

It is contended that money capital is tied up in a long chain of security transactions.

The money capital which is used to buy newly issued industrial shares is believed to flow into “productive channels.” The speculation, which is supposed to tie up capital, is meant to refer only to old shares or to newly issued shares of investment trusts and holding companies which use the funds to buy blocks of already existing securities. The case where the sales proceeds are used forthwith for further speculative transactions so that the money capital is retained on the stock exchange4 is neatly illustrated by Reisch in the following example. “Let us suppose that 10 different shares, A to K, are dealt in on the stock exchange and that the issue proceeds of 1 million dollars each has flowed into the economic system in the ordinary way. A part of these shares, let us assume for simplicity 50% of each, has not yet passed into the hands of investors but has remained in the hands of speculators: these shares form the stock in trade of the speculators and are traded from one to another among them as they see fit. Suddenly a speculative movement sets in and induces investor X, who perhaps borrows from his bank for the purpose, to buy 50% of the volume outstanding of the A shares, which in consequence of his demand rise in price by 10%, for $550,000. The sellers who, in view of the boom sentiment, wish to speculate further, use their sales proceeds to buy up the B shares, whereupon the sellers of the latter again proceed to buy up the C shares and so on. The prices of all these shares naturally rise in consequence and cause the operators on the stock exchange to borrow from the banks to meet the higher prices and/or to facilitate an increase in their holdings of newly issued shares. As these purchases always take time to conclude (from settlement to settlement) and also take place one after the other (A buys from B, B from C, and so on), and continue indefinitely, it is clear that not only the new funds used to purchase shares by X, but other credits besides may be taken for stock exchange transactions without any immediate reflux into the economic system.”5

An example of a long chain of trading supposed to prove temporary absorption.

Reisch does not deny here “that the proceeds of the sale of shares by a speculator who withdraws from the speculative market, finally flow back into the economic process,”6 but at the same time he holds “that it may take a long time—months or even years—before this happens. . . . The argument shows convincingly that stock-exchange operations may temporarily tie up capital and use credit which is not immediately put back into the economic system.”7

The subsequent analysis will show that there are situations in which a temporary locking-up of money capital may take place, but that certain special conditions have to be fulfilled before such situations can exist.

26. In the example above, the allocation of new money capital to the purchase of old securities was said to have led to a rise in security prices and a retention of the money capital in security transactions. It is sometimes supposed that the rise in the level of security prices can be taken as a sure symptom of the tying-up of capital in security transactions. This, however, is not so. A rise in stock prices can take place without there being any money capital on the scene.

No additional money capital is necessary for a rise in security prices.

If A, B, and C are holders of different shares and A suddenly buys B’s securities at a price of 110%, B acquires C’s, and C A’s, all at the higher price, no new money capital is needed to carry out these transactions. Again, if the securities initially held by A, B, and C are bought by bull speculators or investors X, Y, and Z at prices of 120%, there is still, according to the argument of section 17, no necessity for an additional tying-up of money capital.

It seemed important to refer once more to this circumstance that, with or without changes in the person of the holder, a rise in security prices can occur without any increased use of money capital. Cassel has laid particular stress on this fact and was convinced that there would be general agreement with his simple exposition.8 Indeed, so far as the scientific discussion of the problem is concerned, it is fairly commonly acknowledged that the rise of security prices per se can never be proof or a symptom of the tying-up of money capital.

Hence, higher security prices are no proof or symptom of a tie-up of money capital.

27. Granted that security speculation need not tie up capital, we still have to consider whether it may not do so. We are not here discussing the case of bear sellers who let the proceeds of their sales lie idle. The discussion is for the time being limited to the case which Reisch and most other authors regard as the critical one: the case of continually repeated bull transactions.9 We may then ask what are the conditions requisite for a tying-up of money capital?

One of the necessary conditions appears to be connected with the mechanism of payment. The very highly developed settlement technique of stock exchanges introduces conditions that are quite different from those created by the methods of payment used in other markets. If all security transactions came within the clearing arrangements of the stock exchange, and there were no transactions other than those between people who take part in the clearing procedure (brokers and jobbers), then the possibility of the tying-up of money capital would be excluded on purely technical grounds which we shall examine in Chapter VI. For the time being, however, we shall assume that transactions are carried on with cash (coin and notes) or cheque payments. The appropriateness of this assumption becomes clear when it is remembered that the settlement procedure of the stock exchange is restricted to the narrower circle of operators and that transactions between the public and the brokers are completed with the ordinary methods of payment.

Three conditions are necessary for a tie-up of money capital in security transactions:—

—first, that transactions are completed with cash or check payments;—

A second condition which must be fulfilled if there is to be a tying-up of money capital concerns the extent of credit facilities. The volume of credit must have exceeded a certain magnitude—a magnitude which can only be surpassed under conditions of an “easy money” policy—before the bull sentiment of single individuals can develop into a general bull movement.

—second, that credit is made abundant;—

A third condition is that the new issues of industrial shares, and sales of old stocks by people who withdraw from the stock market, are not forthcoming to a sufficient extent, as compared with the flow of money capital to the stock market. It has already been pointed out that the critics of security speculation think that capital is absorbed in unproductive uses only in the case of transactions in old securities, since they do not doubt that when new issues are purchased the capital flows into industry. Now, is it likely that new capital issues will lag behind the flow of money capital onto the stock exchange? How does the demand for money capital by productive enterprises link up with the flow of capital onto the stock exchange? These are the first questions to be dealt with.

—third, that security sales by industrial producers lag behind the afflux of new funds.

28. Whereas a rise in security prices is no proof that an increased amount of money capital is being employed on the stock exchange, an increased flow of money capital on to the stock exchange always leads, other things being equal, to higher security prices. The rise in security prices in turn gives an impetus to new issues. It is obvious that the best time for corporations to raise new capital is at a time when the stock market is firm, thus showing that there is likely to be a ready sale for new securities. If security prices have risen to such an extent that a chance to issue shares above par is offered, such a chance is not likely to be missed.

Higher stock prices call forth new issues.

The issue of shares at higher prices means a corresponding reduction of the cost of borrowing to the firms concerned. If, for example, a firm has to pay 5% on the capital it borrows, the possibility of issuing new shares at 110% of their face value means a lessening of the cost of using capital by about % on the capital and by about 10% on the capital charges.1 Higher share prices mean, ceteris paribus, cheaper credit for issuing corporations. Is it likely that this cheaper industrial credit will fail to find “takers”? In normal times, or in times when entrepreneurs are inclined to be optimistic, there can be no doubt that the demand for long-term capital is not too inelastic. (Some writers deny this, but there is little evidence to support their view.) A flow of money capital onto the credit market leads to a fall in the interest rate until there is sufficient demand, at the lower interest rate, to take up the funds being offered on the market. On the securities market the same process takes place through movements in security prices, so that when there is an increased supply of money capital, the corresponding increase in the amounts demanded appears in the form of new issues.2

The industrial demand for money capital is normally not too inelastic.

We saw in Reisch’s schematic example how the money capital flowing onto the securities market competed for existing shares. In consequence of this competition the prices of these shares rise so that, ceteris paribus, they yield a correspondingly reduced return. This will most likely lead to an offer of new securities on the market or, that is, to a demand for the new and cheaper money capital, just as happens on the market for direct credit when an increased supply of money capital competes for borrowers and in this way pushes down the interest rate. One may argue that at lower interest rates people desire to hold higher idle cash balances, i.e., that they will prefer increased liquidity for speculative motives. The discussion of this argument is reserved for a later chapter. But no one would argue that an increased supply of money capital on the credit market will simply be tied up in an endless chain of transactions: that one capitalist will merely take over the loan made by another. Such an argument would imply that a fall in the interest rate fails to lead to an increase in the amount of credit demanded, and that the new money capital only takes the place of previous loans, which in turn replace other loans, and so on, and so forth. The new money capital would indeed be tied up in an unproductive use, since it would only proceed through a series of credit transfers instead of finding new borrowers. This hardly sounds like a description of anything that is normal, either for the case of funds offered in the form of direct loans or for the case of funds which go into the purchase of securities. (Since we are here discussing a rise in the stock market, we are not concerned for the moment with the low elasticity of demand for money capital which is a feature of times of depression.)

Additional outlets for new money capital will be found without time-taking solicitation among old borrowers.

The effect of a livelier share market in calling forth offers of new shares is an undeniable fact to which every business man will testify. It may even happen in the course of a speculative movement that the supply of new shares outstrips the supply of new money capital: after a series of new issues has been successfully placed, a time comes when further issues “fail,” and the banks have to discourage further flotations because the stock exchange is not capable of taking up any more. This is a sign that all the money capital flowing onto the stock exchange has already found its way into industry. The stock exchange credits are, then, not tied up in “speculative business” but have (except to the extent that a larger amount of cash is being held by the nervous bears) found their way onto markets for consumers’ or investment goods.

New issues may even outstrip the additional supply of money capital.

29. In order to guard against renewed objections that the arguments advanced here pay insufficient attention to the time-factor, it is worth while recalling that in all causal connexions which are analysed by economic theory certain time-lags are presupposed. “The idea of causality is inseparable from the idea of time.”3 The investigation of the “problem of determining the time-coefficients”4 is at present only in its infancy. There is, however, reason to believe that the error involved in assuming that the time-coefficients can be neglected is considerably less in those markets which we are accustomed to call speculative markets than anywhere else in the economic system.5 Moreover, the problem of the length of the lag (if it exists) between a sudden increase in the flow of money capital on to the stock market and the increase in the flow of money capital through security issues into production is further simplified by the fact that stock exchanges have the character of forward dealing markets—whether these forward dealings are carried on openly or in the disguised form of lending transactions. In many cases an order for the purchase of shares will be given at a moment when the purchaser does not yet have the funds available but is anticipating having them available at a somewhat later date. Thus the mechanism through which the increased supply of money capital—in so far as it is not compensated by spontaneous unloading by temporary holders of old securities—produces a corresponding rise in the quantity of capital demanded, may be set going in advance.

Time frictions are generally less important on security markets than in the sphere of production.

The velocity of reaction of the stock market is relatively high.

An attempt to demonstrate the speed of reaction of the stock market by statistical time series is made in the Appendix. There the time series for stock prices and new issues are set forth side by side. The result seems to bear out the theory that the issue of new shares follows immediately the rise in share prices, and that therefore the quantity of shares offered rises as soon as an increase in the demand for shares is perceptible, or in other words that the quantity of money capital demanded increases as soon as there is a noticeable increase in the supply of money capital.

New stock issues follow quickly the rise in stock prices,—

This does not however prove all that had to be proved in order to controvert the argument that a temporary “absorption” of money capital takes place. Even if the velocity of reaction were so great that no time at all elapsed between the rise in stock prices and the new issues, the extent of the reaction might still be too small. The resultant reaction might, for instance, only conduct half or even less than half the flow of new money capital into industry. The fact that the reaction sets in immediately does not prove that there can be no lag between the offer and the taking up of the total amount of capital suddenly appearing on the stock exchange in search of investment.

—but immediate reaction does not prove absence of lag because new issues may not absorb all the money capital supplied.

30. We must not deny, therefore, that our “third condition” (the lack of a corresponding demand for the new money capital) may prevail in certain circumstances. It has to be admitted that situations may arise in which new issues do not come forth to the same amount, or at the same speed, as the flow of new money capital onto the security market. Such is the case when a quick and large increase in the supply of money capital (i.e., the demand for securities) occurs; then the demand for money capital (i.e., the supply of new securities) may not keep pace. The lag of issuing activity behind the flow of capital onto the securities market would, however, not of itself justify the presumption that part of the money capital is not flowing out into production, since the balance might be finding its way into production through the realization of old security holdings by producers. It is quite conceivable that in times of increasing stock market activity, firms which have been holding their own or other securities may decide to sell them and use the proceeds for productive purposes. (Cf. above § 20.) And it is most probable that another part of the money capital that has flowed onto the stock market will make its way, through the realization of security holdings by profit takers, to the markets for consumers’ goods. (Cf. above §§ 18 and 19.)

Deficiency of new issues, however, is no proof of lag, since producers may sell old security holdings.

A situation in which the realization of temporary security holdings together with new issues of productive enterprises lag behind the increased supply of money capital (as according to our “third condition”) can be explained only in terms of an excessive supply. This excessive supply is likely to arise only if the natural sources of money capital—new savings plus replacement funds—are augmented by a large volume of capital from the “less natural” sources of created bank credit (and dishoarded funds).6 Since the extension of these sources of money capital, especially the expansion of bank credit, involves a reduction of the rate of interest charged by the banks below the natural rate,7 our “second condition” makes its appearance. It is only if credit is offered at a rate of interest below the natural rate that the stream of money capital flowing onto the market will reach such proportions that it cannot be taken off fast enough by investment expenditures of industry and consumption expenditures of profit takers. If we picture the process in terms of an “inflow” and “outflow” of money capital, it will appear that there is a temporary “damming up” of money capital in basins created by stock exchange speculation.8

“Inflationary” credit supply may account for excess of supply over quantity of money capital demanded through industrial stock sales.

31. In examining the conditions of a possible temporary tying-up of money capital in security speculation, we have seen that the “third condition” (a temporary lag of the increase in the amount of money capital demanded behind the increase in supply) is bound up with the simultaneous existence of the “second condition” (increase of the supply through bank credit). The “first condition” (the partial absence of the special technique of payment used on the stock exchange) is also closely associated with this second condition.

As will be shown later, the settlement procedure adopted by stock exchange members renders any considerable use of media of payment (in note or deposit form) unnecessary. If professional speculation involves no “damming up” of media of payment, it involves, of course, no “damming up” of money capital either. But the case is not the same where speculation by the public is concerned. The highly developed clearing facilities apply to business between one broker and another, and not to business between the brokers and private speculators who are not members of the exchange. The latter have to make payment in actual media of exchange (by drawing on a checking account) when they buy securities, and to be paid in media of exchange when they sell securities. We shall see later that the habit which prevails in America, for the private speculator to leave the proceeds of security sales with his broker if he intends to continue his speculation, makes such payments unnecessary. But where the broker habitually pays out the sales proceeds to his customers, speculation by the outside public is associated with the use of media of exchange. Usually, however, extensive speculation by the public only sets in when the development of bull sentiment among them is backed up by an increase in the supply of bank money.

The stock exchange clearing is limited to stock exchange members.

Payments between brokers and private speculators may involve cash or bank deposits—

—except if private speculators continue trading by means of brokerage deposits.

Speculation by the general public thrives only on abundant credit.

This argument that persistent bull speculation by the general public cannot develop, no matter how optimistic a frame of mind they may be in, unless they have the funds put at their disposal, will be explained further in Chapter VI. Although the previous analysis will have sufficed to show that stock exchange speculation is likely to tie up money capital only when there is an expansion of bank credit, the chain of reasoning will not be complete until we have examined the mechanism of payment on the stock exchange and of brokers’ loans. Before proceeding to this topic, however, we will take up the question of stock exchange losses.

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“But this is not all, since . . . credit funds as well as savings flow into the markets, thus adding to the original one billion of excess funds seeking investment. Then prices of securities may not be stabilized until two or three billions instead of one billion have been taken out and used for consumption. In that case, an excess of savings would have been converted into an excess of spendings, and production, instead of being depressed or stabilized, would be stimulated.”