Canary WharfEconomy Polarizing Political Economy 

Capital Confusion

By James H. Nolt

Neoclassical economics, the brand featured in standard textbooks, has been mired in conceptual confusion since its founding almost a century and a half ago. It has always intermingled core concepts of capitalism, including money, credit, and, especially, capital itself. Although economics has made significant advances in mathematical and statistical modeling since its inception, conceptual advances are few. Vague and shifting ideas proliferate at its core. No matter how much mathematics is used to obscure the conceptual rot, textbook economics remains an elaborate castle erected on an unstable foundation of sand.

The neoclassical approach started in the 1860s and 1870s with three key theorists: Léon Walras (French), Carl Menger (Austrian), and William Stanley Jevons (English). The approach was consolidated and popularized a generation later by Cambridge economist Alfred Marshall. His Principles of Economics was the most influential textbook of its day. It went through eight editions from 1890 to 1920. This 700-page tome includes most of the contents of any modern introductory microeconomics text, plus some of what is today found in macroeconomics, which was elaborated by Marshall’s even more famous student, John Maynard Keynes.

As I read Marshall today, I’m struck by how little economics has progressed in the past century—and how much has been forgotten. Marshall’s many nuances and qualifications are omitted in modern textbooks in favor of core concepts presented without qualification, as if they are uncontroversial. All the concepts that were ambiguous and confused in Marshall’s original work are still just as muddled today, but now they are rarely questioned. Conceptual confusion remains, but few economists now examine the problems.

Marshall, at least, was explicit about what he was leaving out of his Principles: money and credit. Like the neoclassical founders, he tries to explain as much as possible while avoiding “complications” like the changing value of money and the cycle of expanding and contracting credit—issues he addresses in brief in a later volume, Money, Credit, and Commerce. Unfortunately, few economists subsequently explored the polarized dynamics of the credit cycle.

Marshall shares with modern textbooks considerable ambiguity about capital, credit, and money. The key to clarifying these is to start with credit, the most ignored of the three. Credit creates the cyclical dynamic of capitalism, polarizes owners of capital, and influences the fluctuations of capital’s value. Instead, economics starts with capital, but then confuses the term by obscuring its two forms: productive and financial. I treat capital just as capitalist firms and their accountants treat it, not according to the muddled methods of economics.

Capital within a firm is the totality of wealth used by the firm to generate profit. It can be physical means of production, real estate, or financial instruments such as stocks, bonds, loans, or cash. Capital used is not the same as capital owned. Many firms borrow a portion of the capital they use. Capital duplicates via the credit relationship, being both employed by the debtor and remaining as an asset for the creditor. Students in finance classes learn that a firm must determine how much capital to borrow relative to what it owns, known as equity. Finance teaches how to calculate the debt-equity ratio, reflecting the portion of capital used that is borrowed rather than owned.

Since the inception of this blog series, I have emphasized the crucial polarization between bears and bulls, which is revealed (but insufficiently emphasized) in the core principles of accounting and finance, not to mention actual business practice. Bulls magnify profits by leveraging the capital they own with extensive credit from others. Whenever their rate of profit exceeds their interest cost of credit, they can magnify gains. This is the bull magic.

It might seem everybody would want to be a bull. But capitalism is a two-party system that also generates bears. Collectively, creditors embody contradictory incentives. On the one hand, they profit from lending capital to any borrowers that might be expected to use it well enough to service their debts. On the other hand, if credit expands too quickly, its value diminishes. Those financiers whose wealth is predominantly in the form of credit to others (e.g., bankers or bondholders) have an interest in maintaining the value of credit assets. If credit is too promiscuously issued, credit assets (e.g., loans, bills, and bonds) start to fall in relation to the value of other assets, particularly those assets most demanded by the bullish users of credit. For example, if the credit boom is primarily financing mortgages, real estate prices tend to rise relative to other asset prices. If credit is primarily used for stock speculation, stock prices inflate relative to bonds and cash. Creditors become bears when they see excessive credit expansion undermining the relative value of their own debt assets. Bears take short positions in vulnerable assets, liquidate those that they own, curtail credit, and profit from the resulting price crash.

Economics largely ignores strategic action by assuming perfect or efficient markets comprised of a multiplicity of small, weak actors rather than a few giant financial players organizing strategically. Since the inception of capitalism, there have always been large financial institutions, such as big banks, that can collectively act in favor of creditor interests. When they see credit-driven price inflation eroding the relative value of their own assets (including bonds, loans, and cash), they have the power and incentive to pop the asset bubble by the simple expedient of curtailing credit. New loans are refused, especially to the most highly leveraged and vulnerable bulls. When credit is tight, buying slows, and the hottest asset prices start to fall, while the relative value of creditor assets rises. The bears who pricked the bubble are thus free to buy up the depreciated assets of bulls, desperate to sell to redeem their debts or forced to transfer by bankruptcy. In time, the former bears start the credit cycle all over again with a fresh infusion of credit to a new generation of hungry bulls. The game continues.

Economists teach that capital is a physically productive factor of production, but this only applies to some of it. Much capital that claims a profit is in the form of financial assets that are not themselves productive of anything. At the same time, economists also teach that capital is perfectly fungible—that is, it has multiple productive uses. Financial capital can indeed be applied to multiple uses, but most physical means of production, such as the capital invested in a steel factory or textile machines, are useful as capital only for a single productive purpose. Economists thus blur the two elements of capital—financial and productive—by treating all capital as if it is both at the same time, when in fact it must be either one or the other. When a bond is issued to finance a new railroad, both forms co-exist: the bond as financial capital and the railroad itself as physical capital.

This muddle about capital distracts attention from the strategic role of capitalists, particularly creditors. The allocation of credit is a strategic process, not a market. It always involves the exercise of power and discretion on the part of creditors. They always have a choice to lend or not, to expand credit or not. Their strategic choice is influenced by their own interest as creditors. While they may prosper by issuing credit, they also lose if credit expands so rapidly that inflation erodes the relative wealth of the creditor class. Contrary to economists’ beliefs, markets do not stabilize capitalism, but polarize it between bears and bulls. Over the long run, capitalism acquires only a modicum of stability as the cycle alternates from bullish boom to bearish bust. Capitalism’s antidote to raging bulls is ravenous bears.

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James H. Nolt is a senior fellow at the World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of David Liff]

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