In the previous posting on this subject, we looked at the different ways in which new capital formation could be financed. We discovered that if we assume that only existing savings can be used to purchase new capital, ownership of all new capital is going to be concentrated in the hands of whoever owns those savings. In capitalism, that means a private sector élite, while in socialism that means a government bureaucracy of some sort, whether you’re talking a national dictator or a village council.
|Financial instruments can get complicated.|
What we did not look at was how financing is actually carried out either by the past savings method or the future savings method. This is really quite simple once you get the basic idea, although it involves the use of specialized terms and sometimes even specialized spellings of terms! For example, “endorse” refers to giving something the thumbs up generally. “Indorse,” on the other hand, is putting your name on the line on a legal or financial instrument. Thus, you endorse a bank’s services, but you indorse a bank’s instruments (e.g., checks, promissory notes, etc.).
So, how does past savings financing work?
First off, past savings financing does not work unless you already have something to save. That means you or somebody else is producing or has produced some marketable good or service that you can put your hands on.
|Things are starting to look peachy!|
For example, you own an orchard and have accumulated a warehouse full of apples. You want to plant a grove of peach trees, and the apples as they are aren’t going to do you a bit of good until you can turn them into cash money with which you can purchase peach seedlings.
You aren’t in the business of selling applies, however, and you don’t know who is, so you draw up a contract conveying ownership in your apples to the holder in due course. This contract is called a “bill of goods,” a type of mortgage security. You take the bill of goods to a bank and sell it.to the bank (it’s more complicated than that, of course, but that’s what you’re doing when all is said and done).
You take the money and do what you want with it, which is to buy peach seedlings. The bank takes the bill of goods and sells it to someone who wants a warehouse full of apples, making a profit on the deal. The holder in due course of the bill of goods shows up and you deliver the apples to him or her.
Of course, if you have not produced anything, you have to find someone who has, and persuade him or her to lend you enough to do what you want, on whatever terms both of you find agreeable.
How does future savings financing work?
|We said "bed RIDDEN' not "bed RIDING" . . .|
Where in past savings you begin with production (and there is an implied “chicken or the egg” situation there we won’t get into today), in future savings you start with an idea for something that you want to produce. The problem is you don’t have anything out of which you can produce, except maybe your brain and your body. And if you’re bedridden or in a coma, that isn’t doing you much good if selling your labor is the only way to be productive. Pretty much the only way you can be productive in that case is to own something productive besides labor . . . and that means capital.
But you don’t have any savings with which to purchase capital? What do you do?
Simple. You go to someone with capital to sell, and you promise to pay for it later when the capital becomes productive. You offer an agreement called a bill of exchange that says you will pay X amount on such and such a date or when such and such an event happens and the agreement is presented for payment.
In effect, you are purchasing capital now with a promise to pay for it later. If your promise is good, then it is the same as money . . . in fact, it is money. By entering into a transaction you and the person from whom you are buying capital have created money between you, and when you make good on your promise, the money you created is cancelled.
These, of course, are the simplest case of past savings involving mortgages, and future savings involving bills of exchange. Things can get extremely complicated by making bills and notes negotiable, having banks to accept them and issue promissory notes in place of them, by taking many different forms, and so on. In the end, however, there are two ways to finance new capital formation, either past savings or future savings, and which one you use for a specific purpose can determine what kind of society you have and even whether it’s just or unjust . . . which we will look at when we next look at this subject.