CAPITAL AS PURCHASING POWER
A Functional Definition
FUTURECASTS online magazine
www.futurecasts.com
Vol. 4, No. 8, 8/1/02.
(This article summarizes and modifies a more extensive article published 4/1/99.)
The determinants of purchasing power: |
FUTURECASTS defines "capital" functionally - in terms of its purchasing power -
the evaluation of which has many complexities. It is a very dynamic phenomenon. ? |
Capital constantly waxes and wanes due to volatile factors like profitability, interest rates and perceptions of risk-reward ratios - and the myriad psychological factors influencing confidence. |
Capital is financial - not physical. There is a great overlap with
"credit-worthiness" (herein simply referred to as "credit") and in most instances in
advanced nations, the two are the same. However, there are obvious differences. |
Profits and other returns on capital
- such as tax receipts for governments, and interest, rents, wages or salaries
for private interests - are balanced against all
perceived risks to determine the purchasing power of credit. Without profits
or other return on capital - current or prospective - there is no credit, and capital is worth little.
When profits are reduced or risks are increased, both credit and capital are
reduced. ? At rock bottom - when there is no longer a political or private going concern - capital can indeed be reduced to the market or salvage value of the physical assets - less encumbrances. But then, it is little better than "dead capital." |
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Capital cannot be measured. It can only be evaluated - from moment to moment - somewhat like credit.
In undeveloped nations or communist nations - without legal enforcement of property and contract rights - capital can remain merely a potentiality - "dead capital" - as in an economy run by adolescents. No matter how much is invested, the capital created will be limited by the lack of creditworthiness. |
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A modern legal system - protecting creditors'
interests and interests in property - increases confidence factors
that increase the purchasing power of both capital and credit. In Hernando de
Soto's terms, see "Mystery of
Capital," - it brings "life" to capital. It greatly enhances the value of
property and productive assets and then adds the purchasing power of credit to
its owners. The purchasing power of credit
is complex, as it involves transaction costs and interest costs that vary
depending on the factors that determine creditworthiness. |
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Debt capital is notoriously less flexible than
ownership ("equity") capital, since servicing costs for debt are generally
fixed while profit expectations supporting equity interests can fluctuate.
Entities with few debts are
thus more likely to survive hard times. ? Debt capital reduces confidence as it is used - unless it is invested wisely to earn more than the servicing burdens assumed. However, increases in the level of debt leverage in a business entity or an entire private economy, or increases in government debt as a percentage of tax revenues - always increase the risk side of the risk-reward ratio - with adverse impacts for capital. We don't just "owe it to ourselves." ? |
Like any credit, increases in the money supply can undermine confidence and - by means of the mechanisms of inflation - can reduce purchasing power faster than the government can add zeroes to its currency. |
Currency is dependent on the credit of the issuing
government - supported by various hard currency reserves and physical assets
like gold or oil - but principally supported by confidence in the nation's economy,
productivity and economic policies. Unlike government bonds and notes, currency
is practically "frictionless," since there are only de minimus
servicing costs on this use of the nation's credit. However, like any credit,
overuse can undermine confidence and - by means of the mechanisms of inflation -
can reduce purchasing power faster than the government can add zeroes
to its currency. ? As inflation increases, it first causes capital to stagnate and then causes decapitalization. Not only can inflation occur in the presence of substantial levels of unemployment - it ultimately always causes unemployment. Inflation above de minimus levels cannot be "managed." ? |
One of the most disheartening burdens of inflation is the awareness that a depression must still be incurred to end it. |
Inflation is a form of national bankruptcy - with
creditors getting back only 80 or 60 or 40 cents on the dollar over time. It
ultimately causes so much pain, that it can destroy economies and governments. All nations and
all peoples that suffer chronic periods of inflation ultimately support - and
indeed insist upon - the elimination and avoidance of inflation - despite the
pain and suffering of the austerity at the heart of the withdrawal process. |
Currency and credit are stores of economic value.
They are stores of purchasing power. They are just as much a part of the
mechanism for storing wealth as warehouses and grain elevators. This makes them
highly elastic cyclical factors having important effects on trends of
physical economic exchange and, thus, on the performance of the economy as a
whole. |
Confidence is obviously the key variable in
determining the moment-to-moment exchange value of currency and credit.
Therefore, capital depends on confidence for the growth, loss, and
restoration of its purchasing power. |
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Capitalism is the most ethically based economic system ever developed. It is based on confidence and trust. When trust is undermined - as recently by major auditing failures - capital is diminished. Laws, regulations and customs that promote ethical conduct promote trust and thus maximize capital. |
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There are times when shocks will shake this belief.
However, when government economic policies and the economy are sound and the
economic environment generally favorable, these psychologically caused economic
swings will be brief and of only minor importance - as when Pres. Kennedy was
shot. |
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Even mild recessions deal quickly with outmoded or faulty business plans, various speculative bubbles, and the inevitable houses of cards erected during prosperous times. |
The business cycle exists because human
management - both government and private - is far from perfect. Any
growth of savings that may occur during prosperous times has nothing to do with the cyclical
termination of prosperous periods. ? During prosperous times, outmoded or faulty business plans linger - tendencies towards over expansion and inventory accumulation become burdensome - various speculative bubbles inflate - some houses of cards are erected - and a variety of other weaknesses proliferate in the private economy. These are all dealt with quickly by even mild recessions such as the one that has just ended. ? The threat of imminent commercial death serves to concentrate the minds of private management - forcing the rationalization of operations and major increases in productive efficiency. The weakest producers are swept aside, freeing resources for the next surge of prosperity. This usually arrives in between one to three years - depending on the flexibility of the economy - unless the fundamental causes of the decline are the policy blunders of government. ? |
When government policy blunders are the cause of economic decline, it may take one or more changes of government before appropriate reforms are adopted - stretching the period of economic hardship to a decade or more - as in the 1930s and 1970s. |
Government policy blunders are seldom
eliminated by mere recessions. Decade long depressions or inflations are
required to "git the ahtention" of the political mules. After
all, it's not their money they play with. It's the private sector that bears all the economic burdens and risks of government stupidity and
demagoguery. ? Government policy blunders - socialism, industrial policy, burdensome taxation and noxious tax incentives, trade wars, budgetary deficits, monetary inflation, burdensome laws and regulations, inefficient or corrupt bureaucracy, conflicts, etc. - will generally be maintained and even increased until economic conditions deteriorate sufficiently to threaten political incumbencies. Indeed, politicians can get so attached to their policy blunders, that even depression or inflation fail to move them. It may take one or more changes of government before appropriate reforms are adopted - stretching the period of economic hardship to a decade or more - as in the 1930s and 1970s. ? Today, political paralysis unnecessarily extends economic disruptions in both impoverished Argentina and wealthy Japan. In many undeveloped nations, the leadership just doesn't give a damn about the people - so there is nothing that can be done. ? |
Clearly, capital and credit decline just
before and during the declining phase of the business cycle - despite adequate
maintenance of facilities and continued investment flows during the
initial stages of
the process. However, these are overwhelmed by the declines in profit
prospects and in confidence at these times, as accumulated public and
private policy
blunders undermine prosperity. ? |
The Keynesian definition: |
Capital is not static. It is dynamic. It is
constantly fluctuating under the influence of such dynamic factors as the
business cycle, confidence, profitability, the perceived risk-reward ratio, and
private and government economic policies.
This is the reality of capital - and it is determinedly ignored by many
economists. ? |
Many economists view capital as something relatively
stable. Labor, productive facilities, and natural assets such as land and raw
materials, need only be developed and directed to provide the goods and services
needed by the economy. John Maynard Keynes was of the opinion that, at some
future date, capital assets would accumulate to the point of becoming so
plentiful that there would be no need for further investment. All that would be
needed would be government action to take over these plentiful assets and assure
full utilization for the public benefit. |
Labor theory: |
Labor is truly the basis of an economy. But it is
a "given" in the problem. It is always available. ? |
It is the manner in which labor is exploited that varies, and must be examined to understand why competitive, private enterprise capitalism always provides the greatest good for the greatest number. |
The important variables affecting the value of
labor cannot be measured.
These are the skills of labor, and the ways in which labor skills are developed
and exploited to provide those assets that can multiply the exchange value of a
given quantity, quality and variety of human effort. ? Roughly speaking, socialism and communism exploit labor in one way. Physical slavery or serfdom exploit labor in another way. Autocratic capitalism exploits labor in a third way. And, competitive, private enterprise capitalism exploits labor in still a forth way. ? It is not the availability of labor that is different, and there is no difference in the fact that each economic system must exploit labor if it is to accumulate productive assets. It is the manner of exploitation that varies, and must be examined to understand why competitive, private enterprise capitalism always provides the greatest good for the greatest number. ? |
Productive human skills - the "know-how" - of
both labor and management - both private and government - are the most important
assets supporting the value - the purchasing power - of a nation's capital. This
explains the "miracle" of European and Japanese recovery after the
vast destruction of physical assets during WW-II. Most know-how resides in older
workers and managers who were not deployed to the killing fields of the war. |
Problems with static physical concepts: |
Static physical concepts of capital are obviously unsatisfactory. Among other things, such restricted and oversimplified concepts cannot explain: |
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The business cycle
is still viewed as a "mystery," and economic growth, an inexplicable
"miracle," by a surprising number of economists. They could not explain how all those impressive sums
invested under the Soviet Union's five year plans somehow failed to build up, or
even maintain, Soviet productive capabilities. They had no explanation as to how
the economy of the United States could perform so well and develop so rapidly
despite low and declining savings rates. They were surprised when all that money
lent to third world governments failed to produce any economic growth. |
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Static, physical concepts of capital fail when evaluating
that which at first glance looks like an asset but which may actually be a heavy
liability for the economic system. Such analytical tools still fail to provide
an accurate measure of true economic value. ? If no one wants what you produce, or if one can get it for less elsewhere, productive capacity may stand big, tall and shiny, but it will be completely or partially worth less. Where tariffs or other restraints or subsidies protect a facility or industry from outside competition, the cost to the economy of operating an inefficient industry will increase expenses borne by the rest of the economy. This cost may far exceed the true value of the protected entities. ? The failure exists in the other direction, too. The opening up of domestic or foreign trade and the construction of infrastructure facilitating domestic or foreign trade can create vastly more capital than the sums invested. ? |
Advocacy scholars: |
Why, then, was the static physical concept of capital
so attractive? ? |
Most important of all - labor and capital exploit and are totally dependent upon management for the productivity of their inputs.
De Soto brilliantly demonstrates that human and physical assets without credit constitutes "dead capital." |
Idealists and economists who are advocacy scholars (Krugman
calls them "policy entrepreneurs") find the physical concept of
capital attractive because it permits them to minimize the importance of such
mundane details as finance, risk and profit motive. (The devil of invalidity is
in those details.) |
The value of human capital remains a complete mystery to econometrics technicians. Evaluations of the cultural and social underpinnings of economic and political activity never makes it into their development models. |
For the technicians struggling with macroeconomic
econometrics, the static physical concept of capital is even more
compelling. In order to construct mathematical models of our complex economic
system, they must simplify all economic theory to the point where each of its
variable elements can be mathematically measured or weighted. They must omit all
factors that cannot be represented as equations. They must assume that the many
unknowns grouped in "residuals" do not contain significant variables.
As Keynes candidly points out, this can be said for ALL macroeconomic econometric models - those even with multiple variables - no matter how complex they may be. They inherently MUST still omit outcome determinative variables that cannot be expressed as equations. Because of problems of measurability and definition, they inherently MUST grossly oversimplify many variables that are included.
All macroeconomic econometric analyses should carry this warning paragraph! |
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Copyright © 2002 Dan Blatt