Monday, May 30, 2016

How Not to Limit Capital


We saw last week that existing savings is not a barrier to new capital formation, and thus not to a program of expanded capital ownership.  Today we’d like to conclude our series of rants about the claim that “[financial] capital is finite” by outlining the basic techniques of finance by means of which anyone can become an owner of capital.

First, locate a financially feasible capital project, meaning one that is expected to pay for itself out of its own future earnings.  If a project is not expected to do this, it is not “feasible,” and does not qualify for the financing techniques outlined here.  There may be overriding social or political reasons for undertaking the project, for which a tax subsidy might be justified, but as a capital project, it must pay for itself out of its own earnings.
Yes, we know that conventional wisdom says that you must first reduce consumption below your consumption level — or somebody must do so.  The problem is that if you do that, then any new capital is likely not to be feasible.  That’s because the demand for new capital is derived from consumer demand.  If people cut consumption, then there is little or no need to increase productive capacity by investing in new capital.
That’s why financing for all new feasible capital should come out of future increases in production instead of past reductions in consumption.  Given Say’s Law, current accumulations of savings should be used to purchase existing production, while future savings should be used to finance future increases in production.
Here’s how.  Having located a feasible project, you make a reasonable calculation as to how much it is worth.  If the cost of forming the capital is less than it is worth, it is probably a good investment and it will pay for itself.
You draw up a contract for the amount you need to finance the new capital formation ($98,000) plus a fee for the service of turning the contract into money and a risk premium, say $2,000.  You take and offer the contract to a commercial bank.  The loan officer agrees that the bank will create $98,000 for you to use in purchasing the new capital, and back that new money with your contract to pay the bank $100,000 within a specified period of time.
To make certain it gets its money back, the bank insures the loan, using part of the difference between $98,000 and $100,000 as the insurance (risk) premium, and recognizes the rest as profit, or $2,000 minus the risk premium.  Depending on how the bank decides to handle its bookkeeping, it can recognize its profit immediately, or over the life of the loan.
If the commercial bank wants to be absolutely certain it will get its money back, it “sells” the loan to the central bank, say for $99,000.  The central bank accepts (rediscounts) the contract you drew up, and issues a promissory note to the commercial bank that obligates the commercial bank to pay the central bank $100,000 within a specified period of time.  The commercial bank makes an immediate profit of $1,000, and the central bank stands to make $1,000.
The commercial bank replaces your contract for $100,000 that backs the $98,000 it created, with the central bank’s promissory note for $99,000.  As you repay the loan, all the promissory notes are cancelled, as is the contract you originally drew up.  You end up with $98,000 worth of new capital, the commercial bank has revenue of $1,000, and so does the central bank.
Thus, without relying on any existing money savings in the system, you end up $98,000 richer, and the commercial bank and the central bank are each $1,000 richer.
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