Capital as purchasing power

(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.
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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.
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Of course, physical assets contribute to financial purchasing power. For productive assets - like land, facilities and human strength and skills - their contribution to purchasing power is based on the value of goods and services being or capable of being produced. For buildings, it also includes the value of shelter and the use of utilities. For all saleable assets, it includes the market price.
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While the various hard and human assets provide some solidity, capital nevertheless is constantly waxing and waning due to volatile factors like profitability, interest rates and perceptions of risk-reward ratios - and the myriad psychological factors encompassed in the concept of confidence. More than the goods and services produced, capital is determined by the productive efficiency with which they are produced.
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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.
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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."

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.

NOTICE that money invested in producing or developing capital assets or human skills or goods or services, etc., is not mentioned. Money invested actually has only a tenuous connection with the capital created by the investment. For example, money invested to build and expand production for subsidized or tariff protected domestic markets may actually be a heavy increase in an economic liability for the nation rather than an asset. Here, credit diverges from capital, since these assets may be very creditworthy within their protected markets even though they represent negative capital. Sweat equity and on-the-job learning create vast amounts of capital and credit without measurable investments - and changes in private management or government policies can change the purchasing power of capital without any purchase or sale of capital assets.
NOTICE that capital fluctuates constantly with such factors as profitability, confidence, the effectiveness of management, and government monetary and budgetary discipline and the effectiveness of its economic policies. Threats of terrorist attacks, rising insurance rates, loss of confidence in auditing and financial statements, lack of government budgetary discipline, have all recently seriously diminished both capital and credit within the United States. Capital and credit inevitably fluctuate with the business cycle.
NOTICE that the actual use of credit can either reduce capital and credit - if the sums are used for expenses or invested unwisely leaving debts that enlarge servicing costs more than any sums added to earnings - or can increase capital and credit - if the sums are invested wisely to earn sums in excess of servicing costs.
NOTICE that capital can thus only be evaluated - somewhat like credit - from moment to moment. It cannot be measured. It can exist in diminished form - as a potentiality - without credit - as when adolescents develop marketable skills but have not yet reached the age where they can be legally bound by their contracts. In undeveloped nations or communist nations - without legal enforcement of property and contract rights - capital can remain predominantly 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.
NOTICE that capital is a vital factor that can clearly affect economic outcomes, but cannot be measured or expressed as an equation and thus cannot be included in macroeconomic econometric models - which necessarily are invalid without it.

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.
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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."
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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. ? One of the most disheartening burdens of inflation is the awareness that a depression must still be incurred to end it. No substantial inflation has ever been eliminated without the austerity policies that initiate a depression. The 1980-1982 depression was a significant part of the price that had to be paid to recover from the two decades of irresponsible inflationary Keynesian policies that preceded it. ?
	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. ? With proper discipline and control, they operate to even out the natural peaks and valleys of production and consumption. Without proper discipline and control, they may be misused and may operate to originate peaks and valleys of their own. They are thus a good deal more important than a mere "veil" over the reality of economic exchange of labor, land, facilities, raw materials, goods and services - as some economists have suggested. ?

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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But confidence cannot be measured mathematically. It is a psychological factor in the economic environment. The purchasing power of capital is dependent on this factor and, therefore, cannot be measured mathematically. It is always subject to psychological instabilities.
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However, there are many factors that can serve to counteract these instabilities and give the capitalist system a workable - indeed a robust - level of day-to-day stability.

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.

The actual and potential efficiency of the economy is the most important single factor evaluated by investors and suppliers as a basis for confidence in an economy.
Where currencies are fixed, the balance of payments and fluctuations in reserves of hard currencies and gold are used as indicators to determine whether an economy is strengthening or weakening.
Where currencies are free to float, the appreciation or depreciation of those currencies against hard currencies and gold will impact the time cost of money (interest rates) and the price-earnings multiples of equity interests - and thus the efficiency of the economy and the purchasing power of its capital.
Where debt capital rests on a sturdy foundation of equity capital, confidence in financial stability will be strong. Where debt leverage is great, confidence will be shaky.
Government policies sensitive to commercial needs support confidence - while political and bureaucratic obstructions, burdensome taxation and restraints on domestic and foreign competition undermine it.
Where pertinent characteristics of civil society and culture include support for a work ethic and for economic and political freedom and a rule of law legal system sensitive to the needs of commerce - entrepreneurs, creditors and investors can act with confidence, boosting the purchasing power of capital. 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. Customs, laws and regulations that promote ethical conduct promote trust and thus maximize capital.
Competitive markets promote ethical conduct and trust in the system. Since repeat business is usually at the heart of business success in competitive markets, competition powerfully forces careful attention to relationships between suppliers and manufacturers and with ultimate customers. Where repeat business is not valued (the used car salesman and roadside mechanic are primary examples) or where monopoly prevails, ethics, trust and economic performance suffer.
Then, there is the natural bias towards optimism! Investors and entrepreneurs want to believe that they can make money. Only this can explain the willingness to risk what has already been earned on the uncertain future.

	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. ? But shocks can reveal weaknesses. They can reveal outmoded or unsound business plans, and they can bust financial bubbles and bring down the houses of cards inevitably created during prosperous times. Sudden loss of confidence can trigger vast reductions in capital and credit worthiness, and play a role in the economic business cycle. The Asian Contagion revealed the weaknesses of crony capitalism, but sounder economies such as those of Singapore and Taiwan came through it fairly well although severely buffeted in the eye of the storm. ?
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.
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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.
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This fallacy is similar to that of Karl Marx - and just as obviously stupid. More than 60 years ago, Keynes wrote that the age of plentiful assets would arrive in about 25 years. Keynes, "The General Theory of Employment, Interest, & Money," Part II, "Interest Rates, Aggregate Demand, and the Business Cycle," at segment entitled "Utopia."
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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. ? It also explains why Marshall Plan type aid worked so well in Europe but fails so miserably for so many third world nations. It also explains current problems with economic development in Russia. Seven decades of socialism was more destructive to human capital than the violence of WW-II. Almost all managerial know-how, as well as much of the labor know-how, had been destroyed by socialism. ?

Problems with static physical concepts:

Static physical concepts of capital are obviously unsatisfactory. Among other things, such restricted and oversimplified concepts cannot explain:

The concept of credit;
the monetary value of gold;
the waxing and waning of the business cycle (No! It has nothing to do with savings.);
the processes of economic development and growth - or decline;
the full financial aftermath of war;
the impact of extensive leverage on economic stability (Yes! There are substantial differences between debt and equity capital.);
the importance of profits and profit margins (Yes! It is impossible to provide a valid explanation of capitalism and its success without stressing the many roles of profits.);
the reasons why increased productive efficiency - whether from technology or foreign trade or the development of human economic skills - doesn't cause a loss of jobs within an entire economy (No! There has been no "giant sucking sound" of jobs rushing to Mexico.);
the value of government economic activities - both infrastructure projects (which frequently increase wealth far in excess of expenditures) and the production of goods and services (which frequently actually reduce wealth because of inefficiency and waste);
the value of being able to provide a "hard" currency (No! Currency depreciation does not stimulate economic growth. No economic system has ever prospered with a chronically depreciating currency.);
the manner in which inflation destroys capital (No! Inflation above de minimus levels cannot be managed.); and,
the manner in which real chronic balance of payments deficits ultimately destroy financial stability and economic productivity.

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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However, some progress is evident. Increasing numbers of economists have been conceding that the efficiency with which investments are made is more important than the nominal amounts invested.
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Quality variances are a related problem, and are also finally getting some attention. Productive assets may vary qualitatively in ways not reflected in their purchase price, as may the products they produce. There will always be variances in the quality of management. The value of being able to produce desirable varieties of each product is still totally ignored. (The importance of the myriad factors of quality, variety, and management efficiency have been stressed in the writings of the publisher of FUTURECASTS online magazine since the 1960s.)
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What was the true economic value of Soviet productive assets? What was the economic value of the pitiful inefficient little backyard steel furnaces that sprang up throughout China during the Great Leap Forward? What is the value of the sugar plantations and giant inefficient integrated steel mills in the United States that continue to exist only because of restrictions on imports that cost the economy many millions of dollars?
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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.
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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.
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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.
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Advocacy scholars:

Why, then, was the static physical concept of capital so attractive?
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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.)
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It is attractive to those who - like Marx - want to view capital and management as exploiting and being dependent upon labor while ignoring the fact that labor and management exploit and are dependent upon capital and - most important of all - labor and capital exploit and are totally dependent upon management for the productivity of their inputs.
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Indeed, recent financial problems highlight the importance of management. Investments are not really in businesses or assets - they are in management - and they are dependent on the quality of management. Labor and capital will always eagerly seek out and strive to serve the most effective management so as to enhance their productivity and value.
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Some left wing theorists even attempt the fantastically naive differentiation between "industrial capital" (the Good Guys) and "financial capital" ( the Bad Guys). But de Soto brilliantly demonstrates that human and physical assets without credit constitutes "dead capital."
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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.
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Even the obvious notion of variable rates of investment efficiency create complexity and increase uncertainty. Trying to put numbers on the qualitative differences between similar products or productive assets, or the value of being able to offer more desirable varieties of each product, poses daunting problems.
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Gray market activities - especially important in undeveloped nations - are ignored. The value of human capital remains a complete mystery to them. Evaluations of the cultural and social underpinnings of economic and political activity never make it into their development models.
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As John Maynard Keynes perceptively explained with relation to a few of these weaknesses: "A scientific theory cannot require the facts to conform to its own assumptions." Criticizing an econometric explanation based on a single variable, he wrote:

"The pitfalls of a pseudo-mathematical method, which can make no progress except by making everything a function of a single variable and assuming that all the partial differentials vanish, could not be better illustrated. For it is no good to admit later on that there are in fact other variables, and yet to proceed without re-writing everything that has been written up to that point."

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.

"It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis, such as we shall set down in section vi of this chapter, that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep 'at the back of our heads' the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials 'at the back' of several pages of algebra which assume that they all vanish. Too large a proportion of recent 'mathematical' economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols."

All macroeconomic econometric analyses should carry this warning paragraph!