All of the major schools of economics and most of the minor ones take for granted that all capital formation, whether of new or replacement capital, can only be financed out of existing accumulations of savings. Unless someone or everyone cuts consumption and accumulates unspent income in the form of money, the commonly accepted theory holds that capital formation is impossible. Using basic accounting theory and the accounting equation, Assets = Liabilities + Owners Equity, however, we can easily demonstrate the falsity of the assumption that all capital formation must be financed using existing savings.
An Assumption Unsound in Both Theory and Practice
"Savings" — unconsumed income — is classified under Owners Equity. Owners Equity is, in general, divided into two categories. These are the capital investment accounts and Retained Earnings. Capital investment accounts record money that owners put into the business, such as Common Stock or Contributed Capital in Excess of Par. Retained Earnings are income that is neither used to defray expenses nor distributed to the owners in the form of dividends.
Both capital investment and Retained Earnings account for existing accumulations of savings. The difference is that the savings used for capital investment come from outside the business, while Retained Earnings are generated within the business. Thus, if the financing of new capital investment always came out of existing accumulations of savings, every corporation on earth would routinely charge Retained Earnings or the equity accounts for every purchase of capital equipment, and add the value of the new equipment to Assets.
This is not, in fact, the case. Nor does it make sense on even the most superficial examination. New investment in capital equipment increases Assets. This, of course, also applies to any investment that does not qualify as simple replacement. It does not, however, reduce Retained Earnings. (We can limit the discussion to Retained Earnings because the equity accounts are rarely reduced or increased except when retiring or issuing shares.)
Instead, an increase in, e.g., the capital equipment account — long term assets — has one of two effects. One, the purchase decreases cash or another asset account. In this case all that is happening is replacement of one asset with another. Two, the purchase increases Liabilities. The accounting equation would not otherwise remain in balance; you cannot increase Assets and decrease Owners Equity or Liabilities at the same time.
The real use of Retained Earnings — existing accumulations of savings — in corporate finance is as collateral, not as the direct source of financing. In the usual course of events Retained Earnings can be used as the source of new capital formation only indirectly. That is, a company pays dividends, charging them against Retained Earnings. A wealthy recipient of the dividends who is already consuming up to his or her limit usually chooses to reinvest the dividends instead of using the cash for consumption purposes. Ironically, (re)investors rarely put the dividends they receive from a company back into the company that paid the dividends. Instead, the dividend recipient seeks other investments, diversifying his or her portfolio.
Thus, by paying dividends and relying on reinvestment to finance growth, a company could very well be financing a competitor. This was, in fact, the case early in the 20th century with the Dodge brothers and Henry Ford. Dissatisfied with Ford's dictatorial and unaccountable control of the Ford Motor Company, the Dodge brothers began using their dividends to finance construction of their own company. Ford got wind of this, and reduced dividend payouts.
The Dodge brothers sued for what was theirs by natural right of private property. Ford and the courts, however, managed to redefine the rights of minority owners in such a way as to make minority ownership virtually meaningless. (Dodge v. Ford Motor Company, 204 Mich. 459, 170 N.W. 668. (Mich. 1919).) Ford won the right to withhold dividends and force a sale of minority shares back to the company. Ford then lost millions when the Dodge brothers ended up building a better automobile. The 1926 Dodge made the venerable Model T obsolete and forced Ford to design the Model A and retool all his factories.
The Formation of Capital
This series of postings is not a text on accounting theory and practice. Neither is it a history of financial stupidity. We could go into a lengthy proof of what we stated briefly above, but frankly, it should be self-evident. Instead, we need to take a look at how the assumption regarding the necessity of existing accumulations of savings for financing new capital formation has harmed economic growth and stability.
The "slavery of savings," as Louis Kelso and Mortimer Adler refer to it in the subtitle of their second collaboration, The New Capitalists (1961), disassociates the financing of economic growth from the inherent productive capacity of an economy. Economic growth becomes seemingly irrevocably linked to what was produced previously but not consumed.
We should make clear at this point that when Kelso and Adler referred to "the slavery of savings," they meant existing accumulations, necessarily achieved only by reducing current levels of consumption. Obviously, given this definition of savings, people who cannot afford to cut consumption cannot save, however heroic their efforts. This limits the power to save to those wealthy enough or with an income sufficiently large to be able to reduce consumption without suffering hardship. At a certain point, in fact, if one's income is far greater than what can conveniently or even easily be consumed, attempting to consume all of one's income becomes ludicrous, if not suicidal.
Labor by itself cannot generate sufficient income to supply both consumption needs at an adequate level and savings sufficient to finance new capital formation in any appreciable amounts. Technology, that is, capital, alone has the potential to increase production to a level beyond that of bare subsistence. This is true even at the most primitive state of development. Technology even in the form of a club or a thrown rock makes hunting and gathering possible at a higher rate of efficiency and productivity than was previously possible with mere human limbs, teeth, and nails.
To claim that even the most primitive technology only enhances human labor is a profound error. Technology replaces, it does not enhance or change human labor. Climbing a tree to pick fruit is a fundamentally different task (use of labor) than picking up a club or long stick and from the ground knocking the same ripe fruit off the tree. The stick or club and the reduced labor involved in picking up and swinging the stick or club replaced the greater labor — and inherently different task — involved in climbing the tree.
Technology — capital — is thus independently productive. We do not say that capital is autonomously productive, at least in its early stages, although computers and robotics make autonomous production by technology a possibility. Instead, what we mean is that capital and labor are "independent variables" in the production equation, e.g., x + y = z, where x is labor, y is capital — and independent variables — and z is production, a dependent variable (the result of manipulation of the independent variable(s)).
We say "e.g." — "for example" — rather than "i.e." — "that is" — because (obviously) we do not know from one type or level of technology to the next what the "mix" is, that is, how much labor in combination with how much capital of what type will generate what quantity of production. Instead, what the extremely simple, perhaps oversimplified equation shows is that the inputs to production are independent, not dependent variables. As expressed in the equation and as a matter of pure mathematical theory, either labor or capital could be removed from the equation and there would still be production.
Whether either labor or capital can in reality be removed from the production equation is a different issue. Obviously, it is possible to produce something without adding any capital at all, or our ancestors of the distant past would never have survived to invent capital tools to make the task of survival easier. Almost as obvious is the possibility of removing all direct human labor from the production process so that capital operates autonomously. How this could be done, however, is not our concern. We only want to make the point that labor and capital are independent, not dependent variables in the production equation.
The Connection to Humanity
The independence of labor and capital as factors of production raises another question: what connects the human person to production, and thus to the income generated from the production of marketable goods and services?
With human labor, the answer is obvious. Absent a condition of involuntary servitude (slavery), someone who produces by means of his or her labor alone is due everything produced by means of that labor. Each person has the natural right of private property in his or her own labor, and is due the "fruits of ownership," that is, control over how his or her labor is used, and to the full enjoyment within the bounds of the common good of whatever is produced by his or her labor.
The human person is inseparable from his or her labor. Someone may legally or illegally be prevented from enjoying the fruits of ownership — control and income — but labor cannot be separated from the human person or "congealed" as Marx claimed. Labor is "attached" to the human person by nature itself; it is physically impossible to employ labor without employing the "attached" human being. Labor without a human being is a meaningless concept.
Although it might not seem quite as obvious to modern intellects pummeled into near-insensibility by the doctrines of socialism, someone who produces by capital alone — that is, by ownership of capital without him- or herself working with the capital — is entitled to the same rights as the owner of labor. Private property is a "natural right," that is, someone is not considered a human person unless he or she has the right to be an owner secured to him or her and protected. Some other natural rights are life, liberty (freedom of association), and "pursuit of happiness" (the acquisition and development of virtue).
These other natural rights (although obviously we cannot list all natural rights here) are, however, effectively meaningless without private property in the means of production — ownership. This was why, for instance, Aristotle called the non-owning worker or artisan a type of slave. Someone who does not own capital in addition to his or her labor is, to all intents and purposes, without rights — and being without rights is the legal definition of slavery.
That is, we must not only recognize that human beings have natural rights and pay lip service to those rights, we must ensure that society is arranged in such a way as to make the exercise of those rights effective. This necessarily means that each person must have power — the "ability for doing" — in order to exercise his or her natural rights. Private property in the means of production confers this power, whether in labor or in capital.
The Power of Property
This is because "property" is not the thing owned, but the natural right to be an owner, and the derived rights that define what an owner may do with what he or she owns. Obviously, it is in the best interests of society to define the exercise of rights in a way that does not ordinarily result in harm to the owner, to other individuals and groups, or to the common good as a whole. On the other hand, despite the perception socialism inculcates that ownership itself is the problem, the exercise of rights must never be defined in any way that effectively negates the natural right to be an owner.
The right to and the rights of private property therefore naturally connect the human person to capital in exactly the same way that they naturally connect the human person to labor. There is only one difference between ownership of labor and ownership of capital. With respect to the right of private ownership of labor, we recognize a tangible connection to the human person in the form of its inseparability from the physical being of the human person. With respect to the right of private ownership of capital, however, we recognize an intangible connection in the form of legal title recognized, defined, and protected by society.
Only an arrant materialist could deny that the intangible connection of legal title is substantially the same as the tangible connection of physical inseparability. Both are based solidly on nature itself, that is, on moral laws either reflecting God's Nature, or dictated by the laws of nature, the "rules" He laid down for the physical operation of the universe. The substantial nature of both ownership of one's own person and ownership of capital or other things is the same. Only the form — the "accidental" — is different. Taking someone's labor by enslaving the person or unjustly preventing that person from becoming free (punishment for a crime is a separate case and is considered "just title slavery") is inherently no different from depriving someone of the fruits of ownership of capital, or preventing someone from becoming an owner in the first place.
Is the Exercise of Property Ever Absolute?
Many people (socialists in particular) have raised objections to the claim that private property is a natural right. This is because a natural right is absolute. The human person, obviously, possesses a natural right by nature itself, that is, by direct and irrevocable grant by a Creator as part of the definition of humanity itself.
Socialists declare that, because private ownership of the means of production causes (or appears to cause) so many problems, the right to property cannot truly be a natural right, despite the testimony of the universal prohibition against theft and the age-old belief to the contrary on the part of the human race as a whole. Everyone, so the socialists claim, has the right to enjoy the fruits of ownership — the rights of property — but no private person has the right to own. Private ownership is a matter of prudence, to be determined by society, usually in the person of the State.
Socialists thereby confuse the natural right to be an owner, with the derived rights that define how an owner may use what he or she owns. Capitalists also confuse the right with the exercise of the right, but their oddly similar error is to assert that only a few people have the effective right to own (capitalists usually pay lip service to the universal right to be an owner, but qualify its application), but that this elite's exercise of the rights of private property is absolute.
The correct understanding of private property avoids the errors of both socialism and capitalism. That is, every human being has by nature itself the right to own. This is absolute. What may be owned, and in what manner ownership may be exercised is, however, a different issue. The exercise of property, as is the case with any right, must be limited in some fashion. The exercise of the right to be an owner must be defined according to the wants and needs of the owner, other individuals and groups, and the demands of the common good as a whole. The only caveat is that the exercise of property must never be defined in any way that negates the natural right to be an owner.
Are there, however, circumstances under which what someone owns may be taken away from him or her? When an owner may justly be deprived of the exercise of his or her rights or even the possession of what rightfully belongs to him or her?
The answer is, yes — and the justifying circumstances are both more and less common than we might think. First, of course, death imposes a natural limit on the exercise of any right. Then, no one may use either labor or capital to harm him- or herself, other individuals or groups, or the common good as a whole. Second, using labor or capital in the commission of a crime makes the labor or capital subject to confiscation by lawful authority. The owner in that case has demonstrated that he or she is not sufficiently mature or developed, and must be deprived of the exercise of his or her rights until such time as he or she can learn to use them properly.
There is also an aspect of punishment as well as rehabilitation. Depending on the gravity of an offense, an owner may be deprived of his or her rights permanently. For example, someone who has used his or her automobile to smuggle illegal drugs cannot demand the return of that automobile, even after serving a prison sentence and reentering society after presumably being fully rehabilitated. Neither may someone justly retain the income — the fruits of ownership — realized from carrying out illegal activities.
This does not, obviously, apply in the case in which ownership has itself unjustly been made illegal. No one can justly argue that private ownership is in and of itself a criminal offense and on that basis confiscate either what is owned or the fruits of ownership.
There are even circumstances in which, although an owner has committed no crime, what he or she owns may be confiscated for the common good. If at all possible, of course, the owner must be justly compensated, although this may not be feasible immediately in an emergency. For example, in a national emergency, the State may commandeer goods and even services, whether or not the owner is willing to sell or serve. This justifies increased taxation to relieve widespread distress, direct confiscation of goods to feed and clothe people in a famine, and even conscription into the military in time of war.
This does not, however, mean that such measures as increased taxation, confiscation of wealth, or conscription can ever be justified as a usual thing. They are expedients to address an emergency, not the normal way that a society should operate. In social justice, when faced with a situation that demands such extraordinary measures, the proper course of action is to do what is necessary at present, as long as it does not come into conflict with the precepts of the natural law. At the same time, however, it is our responsibility to organize with like-minded others and work directly on the institutions of society in order to make the expedient unnecessary in the future.
Putting It Together
With this understanding of private property, we can see that, just as someone who owns labor is due the share of production due to labor, someone who owns capital is due the share of production due to capital, as the relative value of each is determined by the free market. We also see that someone who owns capital has a natural right to whatever he or she happens to save out of the income generated by the owned capital, just as someone who owns labor has a natural right to whatever he or she happens to save out of the income generated by the owned labor.
We are now in a position to understand what is due to the owner of savings, whether the source of those savings is income from labor, or income from capital.
All the major schools of economics are in substantial agreement that savings equals investment. Economists may differ, sometimes wildly, on what they mean by "savings," "investment," and even "equals," but few will disagree with the basic equation.
As will become apparent in the course of this series, we reject the meaning of "savings" as restricted to existing accumulations acquired by cutting consumption. This, however, is the meaning assigned to the term by the major schools of economics and virtually all of the minor ones. That being the case, owners of existing accumulations of savings are necessarily the owners of existing accumulations of capital.
Owners of savings and owners of capital are therefore entitled to the same rights as owners of labor. Savers and owners of capital have the right to control the use of their savings and capital, and the right to enjoy the fruits of ownership. (Note that we restrict the term "capitalist" to the member of the owning elite in a society in which ownership of the means of production is concentrated in relatively few private hands.)
The Taxonomy of Profit
At this point we need to be aware of some differences in terminology that have confused many people through the centuries. Although the natural right to receive the fruits of ownership is the same, regardless of the source of those fruits, we have different terms for the fruits depending on the source. This has, unfortunately, convinced many people that because the terms are different, the substantial nature is different. That, however, cannot be the case. The substantial nature of a thing defines what it is; a human change in definition can in no wise change the substantial nature of anything — it is beyond human power to "re-edit the dictionary" in that sense.
When the fruits of ownership derive from the sale of labor to another, we call the income "wages." When the fruits of ownership derive from an owner working with what he or she owns, we call the income "profit" — it is unnecessary in that case to distinguish between the results of the contribution of labor and the results of the contribution of capital, because the owner of labor and the owner of capital are the same person. Legally and for tax purposes these can be separated (although sometimes the division is questionable), but for the purposes of this discussion it would be an unnecessary refinement and a diversion.
Confusingly, "pure" ownership of capital, that is, the case in which the owner does not work with his or her capital, is also called "profit." We subdivide the fruits of ownership from capital into two types, however, based on whether the capital is "consumed by its use." When capital is presumably used up or worn out in the process of producing marketable goods and services, we call the profits received "interest," from "ownership interest." When the capital is presumably not used up or worn out in the process of producing marketable goods and services, we call the profits received "rent." Land being the only form of capital that traditionally is presumed not to be used up by its use, classical economics restricts the term "rent" to income from land and the permanent fixtures on land, such as dwellings and outbuildings.
Today, we usually use "rent" to mean a charge for something that is not "used up" or consumed, and which can thus be returned to the owner. Some economists call interest on savings "rent," but that is incorrect: you cannot return the same money you borrowed; money is "consumed by its use."
The precise explanation as to how this happened is important, but complicated. The following two paragraphs may be skipped by any reader who is satisfied with the explanation that the term "rent" is incorrect when applied to "interest."
Over the centuries, the term "rent" has come to be applied to instances in which an owner sells the temporary use (the "usufruct" — the "use of the fruits") of an asset that is not immediately (directly) consumed by its use, but is only subject to incidental wear and tear, that is, mediately (indirectly) consumed by its use. Thus, although a machine is eventually "consumed by its use," this wear and tear (wearing out) of the machine is incidental to the use of the machine. The term "rent" may therefore properly be applied to the fee charged by an owner of an asset for enjoyment of the fruits of ownership of that asset by another. Thus, you can rent a suit of clothing, but you cannot rent money you spend or invest, or a dinner you eat.
In the same way, the term "interest" evolved to mean not just the return due to the owner of capital, but also the return due to the owner of the savings by means of which the capital is financed. This is logical, for if you own savings in the same way you own capital, then the return to the owner of savings and the return to the owner of capital are, to all intents and purposes, the same thing. Over time, however, "interest" has come to mean the return to the owner of savings, and "profit" the return to the owner of capital.
These changes in terminology have led to the illusion that money as money somehow generates a profit in and of itself, and that "interest" is somehow either the rent or cost of money. To understand how we can talk about "interest-free money," then, we need to understand two things. One, we need to know how a misunderstanding of money, and two, how a misunderstanding of interest, have led to the adamantine belief that only existing accumulations of savings can be used to finance new capital formation. We will then be in a position to understand how this has led in turn to the current economic crisis that has brought the world to the brink of disaster, and may at any moment push it over.