The Stock Market, Credit and Capital Formation

CHAPTER V

THE LOSS OF CAPITAL IN STOCK EXCHANGE SPECULATION

32. While it is perfectly clear that an individual capitalist or speculator may make losses on the stock exchange, it is very doubtful whether “society” can make such losses. We are not, of course, referring here to the losses of one society to another, for instance, to the losses which the inhabitants of any particular country may suffer in respect of investments or stock exchange operations abroad. The question with which we are concerned here is whether an individual’s losses from domestic stock exchange transactions represent a loss to the society to which that individual belongs.1 Before we answer this question we must, however, investigate the causes of stock exchange losses.

It is questionable whether stock exchange losses of individuals represent losses to society.

A holder of shares suffers a loss when the shares depreciate in value: this may be due to (a) damage or destruction of the real capital of the enterprise; (b) a fall in the prospective profits of the enterprise; (c) consumption of the capital of the enterprise; (d) a rise in the rate of interest at which the profits have to be capitalized; (e) a misdirection of investment by the enterprise; (f) a reaction to a previous speculative over-valuation of the shares.

There are several reasons why stock prices may fall:—

From the standpoint of the “community as a whole” these various causes merit different judgments:

(a) When real capital is damaged or destroyed there is undoubtedly a loss of social capital. The fall in the price of the shares is not, of course, an additional loss; it is simply the way in which the loss to society is expressed on the market.

—real capital may have been damaged,—

(b) The fall in the profitability of the enterprise may have various causes. If the demand for the product of the firm declines and the reduced selling price of the product diminishes the firm’s receipts, then the investment of capital in the particular line of production concerned may turn out to be unjustified; in any case the fall in value of the firm’s capital simply represents an adjustment which is expressed by the market in the form of a fall in the price of the shares. The same is true when competing concerns using improved technical methods are able to push down the selling price of the product. The fall in the profits of the firm using the old methods and the reduction in the value of its shares will be more than compensated by the profits of the up-to-date firms and the gain to consumers; thus it cannot be regarded as a loss to society. Profits may. be impaired by a rise in the prices of certain necessary means of production; such a price rise may be caused by a competing demand for these factors by other, more promising types of employment. In this case the fall in profits is not to be regarded as a loss to society. If, however, the decline in profitability is not due to an economic process of adaptation or development, but to some “harmful” interference from outside, then we may say that there is a social loss of which the market takes cognizance through the fall in security prices.

—profit expectations may have fallen because of changing conditions,—

(c) The consumption of a firm’s capital may be due to wrong accounting methods, bad tax laws, or bad business practices, which result in the distribution or taxation of “fictitious” profits. To meet these disbursements the firm either uses up part of the necessary replacement funds (e.g., it makes inadequate allowance for depreciation) or it raises new capital (it waters its share capital or contracts new debts). In these cases the fall in share prices obviously signifies a diminution of social capital.

—capital consumption may have taken place—

(d) A rise in the rate of interest must, if the productivity of the enterprise is unaltered, cause a reduction in capital values and consequently a reduction in share prices. If the rise in the interest rate is due to a shortage in the supply of capital, it may be considered disadvantageous from the collective standpoint; if it is due to an increased demand for capital arising out of technical progress, it may be regarded as beneficial from the collective point of view. The fall in share prices does not, therefore, permit the inference that a loss to society is involved.

—the interest rate may have risen—

(e) A misdirection of investment, i.e., the use of money capital for the creation of real capital which yields a return below the marginal productivity of capital in general and is therefore unprofitable, is equally “regrettable” from both the private and the social point of view. Since over-speculation on the stock exchange has sometimes been deemed a cause of misdirection of investment, this point demands special attention.

—investment may have been misdirected—

(f) The losses ensuing from the reaction of the securities market which is bound to occur sooner or later if prices have been driven “too high” by speculation, are what people usually refer to when they speak of “stock exchange losses,” and are the target of their most vehement criticism. These losses, however, are exclusively shifts in the distribution of wealth and of income: they do not in themselves represent any loss to society. This point is not clear even to many trained economists and probably needs to be explained in greater detail.

—speculation may have driven stock prices too high.

Although cases (a) to (d), and others of a similar kind, undoubtedly represent losses to the owners of the securities, they are not losses specifically connected with stock market operations, since the cause is in each case on “the commodity side” and the changes in the share prices are merely a reflection of economic events in the sphere of “real goods.” The only relevant cases for our purposes are case (e) which raises the problem of whether security speculation causes misdirection of investment, and (f) which raises the problem of whether security speculation can cause capital to be lost in the actual speculative transactions themselves.

33. For the moment we will postpone discussing the question of misdirection of money capital; in this chapter we will try to show that money capital cannot be lost in the transactions connected with security speculation. This is not difficult. It would be much more difficult to explain why many an economist has gone astray on this point. The argument that the money capital which flowed onto the stock exchange might be “held up” for a certain length of time undoubtedly made sense. The idea that money capital can be lost on the stock exchange seems, however, to make scarcely any sense at all.

If we reproduce the arguments used by Professor Reisch, we shall see how a rather obvious error led this well-known author to jump from his statement that the sales-proceeds of shares “do not always flow back into the economic process,” to the statement that they “may be used for speculating on the stock exchange and perhaps be lost there.”2 Reisch describes the course of events as the result of which “some part of the capital contributed . . . is in danger of being lost” in the following way3: “The share prices had reflected unreal (artificially high) values; they were soap bubbles which, when the speculative movement ceased, knocked into each other and burst, leaving only a small foundation of real value. On the speculative market a long series of business transactions are concluded but only the balance flows into the economic process.”

Some writers claimed that money capital might be definitely lost in speculative stock exchange transactions—

Reisch here takes a more radical position than he did in his first article on the same subject.4 There he still held the opinion that with the cessation of the stock exchange boom the monetary media which had been used and had of course represented money capital, “become available again for use in other spheres of economic activity. . . . The gains and losses of the speculators are for the most part5 of no significance to the community as a whole, since though they cause shifts in the relative wealth of the participants in the speculative operations, they do not change the wealth of the community as a whole.” In his second article, however, Reisch holds that, in addition to the shift in the distribution of capital ownership, there is a capital loss to society. When stock prices break, so he reasons, “the lower selling price of the speculators is, it is true, balanced by the lower buying price of the buyers, who may be assumed to be outside the speculative market; but the speculators have lost both the gains which they made in the boom and part of their original capital, and in some circumstances they may not even have the wherewithal to pay back the loans they borrowed from the banks, so the banks which have obligations to meet and now cannot obtain the expected equivalent (repayment by the speculators out of the proceeds of security sales) may suffer losses on their assets. This should suffice to show,” so Reisch concludes, that, in addition to the temporary tie-up of capital and credit, “price changes may occur on the stock exchange which make it questionable whether the capital and credit will flow back even later.”6 This “capital and credit,” which must have been represented by circulating media, thus disappears without leaving a trace: It has obviously ceased to be tied up after the speculative boom has come to an end, and yet, so it is contended, it has not “returned” to the economic system—it must then have completely disappeared.

—and that in addition to a shift in the distribution of capital ownership, capital might be lost to society.

Where are the borrowed funds which allegedly failed to flow into the economic process or back to the banks, and are no longer tied up by speculators?

The reason why the attempt to trace the lost money capital was in vain was that the only persons followed up were the persons who last acquired the shares at a low price, the speculator who sold at a loss, and the creditor who might suffer as a result of this loss. But one does not have to be a very good detective in order to reason out that the speculator who sold at a low price lost because he had bought previously at a high price, and to discover, thus, that the money which is being searched for must have gone to the person who sold at a high price, or to use the jargon of the stock exchange, to the person who “got out in time.”

The funds have gone, of course, to those who sold at high prices.

No reader of this book will, I hope, make the mistake of thinking that nobody or only very few people manage to “get out in time.” There are two parties to every transaction; so to everybody who bought at a high price, there must correspond somebody who sold at this high price, and who then stopped speculating and so was the lucky recipient of the money capital which was believed to have been lost.

34. Arguments concerning the losses which society is supposed to suffer as a consequence of stock exchange losses usually consist of a confusion of a number of different ideas. Among these are the following: (1) real capital is lost; (2) money capital is lost in the sense that sums of money which would have flowed onto the markets for producers’ or consumers’ goods fail to do so; (3) money capital is lost in the sense that sums of money which would have been available for productive investment are diverted into the channels of consumption and thus flow onto the consumers’ goods market instead of onto the producers’ goods market; (4) money capital is lost in the sense that bank credit which was granted for purposes of speculating on the stock exchange cannot be repaid and thus fails to return to the banks. The last quotation from Reisch is evidence that this confusion prevails and no doubt many more examples could be cited.

Some arguments about stock exchange losses contain a mixture of ideas which are confused

Many of these ideas are, however, inconsistent with one another. On the one hand stock exchange losses are accused of having deflationary effects (No. 2), while at the same time it is feared that, as a result of stock exchange losses, bank credits will not be repaid to the banks (No. 4). But what does this last effect imply? It means that the economic system remains more amply provided with circulating media than would have been the case if the credits had returned to the banks. Let us assume a case of a very heavy stock exchange loss. Suppose that the banks have created credit in order to provide a number of speculators with funds for buying shares which later turn out to be worthless. The unlucky buyers of these shares have transferred their deposits to lucky sellers of the shares, and the former are therefore unable to repay their debts to the banks. In short, the stock exchange losses in this case prevent the “deflationary” effects which the repayment of credits may possibly have; if they are not repaid, the bank deposits remain in existence, whereas if they are repaid they are, temporarily at least, destroyed.

—and self-contradictory.

Heavy losses and failures of borrowers may reduce credit deflation—

This (slightly frivolous) manner of reasoning serves to show the danger of carrying arguments to extremes and the need for exercising very great caution in analysing economic problems. If we make the argument even more extreme, we obtain quite different results: if the failure of the speculators to repay their loans caused the banks to get into such difficulties that they had to close down, then the immediate result would be the destruction of all their deposits. In this case the failure to repay bank credits would be more deflationary than their repayment.7

—if the banks can stand them.

35. In other cases also it can be shown that, theoretically at least, the exact opposite of the expected and feared results is conceivable. Let us take the case of a reduced capital supply due to the consumption of gains made on the stock exchange (No. 3 in the list of interpretations given above). We have already referred to this case in Section 18. The money capital employed to buy shares comes into the hands of the seller, and if he chooses to look upon part of this money capital as profit and uses it for consumption purposes, then the funds available as money capital are reduced in favour of the funds used for consumption.

Usually the consumption of stock exchange gains is held to reduce the net supply of money capital;—

At first sight it may seem paradoxical to argue that losses on the stock exchange are capable of resulting in an increase of money capital. The conditions necessary for this to take place are, however, not at all unreal. All that is necessary is that the seller should cover his losses out of his income by restricting his consumption. Let us take the case of an occasional speculator who borrows from his bank to gamble on the stock exchange and buys securities at high prices. The fortunate seller—it may be another speculator or it may be a corporation which has just floated a new issue of shares—receives the full amount of the money capital; the unlucky speculator later sells out at low prices and so receives less from the new buyer of the shares than he himself had paid previously. If he now makes up the deficit on the debt he owes to his bank by reducing his consumption, thus saving a part of his current income, and if the banks reinvest the repaid amounts, the stock exchange loss will have resulted in real capital formation. As the individual concerned would not otherwise have decided to save, we might call it a case of involuntary saving induced by stock exchange losses. (If, however, the “make-up savings” of the losers are not invested, deflation results. Incidentally, this outcome is the more probable owing to the pessimistic attitude which follows heavy losses.)

—likewise money capital may be increased if stock exchange losers reduce consumption and if these savings are invested;—

Again, short-term savings may be involuntarily converted into long-term savings as the result of losses made on the stock exchange. If A is saving for something that he intends to consume at a later date (such as a long journey or the purchase of an automobile) and invests these savings for the time being in shares, he makes his temporary savings available for the creation of real capital. If, after having bought the shares at 100, he fails to find a buyer who will take them at this price, and finally has to sell them to another saver, B, at 80, then 80% of the money capital invested in the real capital will have been provided out of B’s savings and 20% out of savings which have been involuntarily sacrificed by A. Although A merely wanted to invest his funds temporarily, he was unable to withdraw them from the productive process, and so the loss he suffered on the stock exchange became long-term savings of the economic system.

—likewise the stock exchange losses of temporary savers reduce dissaving and thus increase the net supply of money capital.

We have no way of telling how important quantitatively the savings induced by stock exchange losses in practice are. Presumably they are considerably less than the figure for consumption of gains made on the stock exchange. But the principle is significant, that the consumption of savings induced by stock exchange gains does have a counterpart in the formation of savings induced by stock exchange losses. In the one case the speculator looks upon his gains as an addition to his income and increases his consumption, and in the other case, the speculator considers his losses as a diminution of income and reduces his consumption. In so far, however, as these gains or losses are regarded not as changes in income but as changes in wealth, they represent merely interpersonal shifts in wealth, which may be connected with the valuation of capital but have of themselves nothing to do with the formation or consumption of capital.

Saving because of losses is the counter-part to dissaving because of gains.

Gains and losses affect saving only when changes in wealth are regarded as changes in income.

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