Monday, December 19, 2016

Capital and Money Are Not The Same Thing

The word "capital" is bandied about as if the word had a concrete, common, well understood meaning. But does it?

For economists, capital is the third fundamental category of scarce resources --- as in land, labor, and capital --- categories that every faithful student of ECON 101 no doubt memorized. On this account, capital includes factories, equipment, and tools. On another account also used by economists, people are said to be investing in and building "human capital" when they go to college or invest time and money to learn new skills. On both accounts, capital is said to be the fundamental source of rising productivity of labor, without which, rising labor income is not possible.

In financial contexts, the word capital most often seems to mean simply "money." On this account, capital is said to "flow" to its highest valued use, if markets are free, to flow between countries, if unrestricted by governments and their central banks, and to be the life blood and wellspring of economic growth and prosperity. Businesses are sometimes said to be "capital constrained" or "under capitalized." Countries are sometimes said to restrict capital outflows (e.g., China), or to attract capital inflows (e.g., America).

Researching the etymology of the word, we find that an early meaning of the word "capital" is from the medieval Latin capitale, meaning a "stock" of something. On this account, one could have capital in the form of grain, cattle, gold or just about anything of value --- including a stock of money.

But on all accounts, the word "capital" really means something beyond simply money. To accumulate a stock of anything requires saving, as opposed to consuming or using up the thing. Hence, money can be capital, but not all money is capital. How so?  Income that is saved in the form of money is capital. But newly created money --- which is to say money created from "thin air" by commercial banks and the Fed --- is not capital.

The world is awash in money these days. But the world is not awash in capital. Is it mere coincidence that the substantial slowdown in growth of GDP in America over the most recent eight years correlates substantially with rapid growth in newly created money, much of which now resides in reserve accounts of commercial banks? Or is it a slowdown in accumulation of real capital --- which requires saving --- that better explains the slowdown in economic growth?

A second early meaning of the word "capital," also from medieval Latin, is capitalis pars, which designated the principal sum of a money loan. In medieval days the principal sum of a loan of money pretty much had to come from money saved. In those days, it was easy to understood that one could not borrow money that had not first been saved. Consequently, if one borrowed, one would typically be borrowing capital.

Not so in today's world of commercial banking, central banks, and money created from nothing. So called "quantitative easing" does not create capital; it just creates new money. In the United States, the Fed purchased Treasury bonds with that money, enabling the federal government to continue increasing its spending.

If some of that spending finds its way to you, you probably don't mind. And since none of that increased spending requires reduced spending by someone else, no worry, right? It's rather like a free lunch, right? Except, there ain't no such thing.

Yes, here I am, beating an old dead horse once again. You can't borrow that which has not first been produced and saved, an idea I've written about before, here.  But you can borrow newly created money, which amounts to a kind of counterfeiting. Here's how it works.

You deposit $1 in your bank account, say a dollar of income you earned by working. By law, the bank is allowed to lend 90 cents of your dollar to Tim. The bank must hold only about 10 cents in its reserve account with the Fed. Now you have $1 that you can spend, and Tim has 90 cents that he can spend. Where did the 90 cents of purchasing power come from? Thin air, as they say.

You created your $1 dollar claim over goods and services by providing a service called labor. But Tim created no goods or services in return for his newly created command over goods and services. Does Tim's new claim on goods and services somehow seem bogus?  You decide.

When Tim spends the 90 cents, that 90 cents shows up in another bank pretty quickly. The second bank is allowed by the Fed to lend 81 cents to Bob. If you like math, you can see where this is going. If the banking system as a whole does all the lending its allowed to do, retaining only 10 percent of deposits in reserve, your original $1 deposit into the banking system can result in up to $10 additional money created from thin air.

The federal government would consider it a grievous crime if Tim were to counterfeit 90 cents on his own and spend it, but it's somehow not a crime if the commercial banking system does what amounts to the same thing.  To add insult to injury, the banking system earns interest on its loans of your dollar to Tim, Bob, and so on. If you have an interest bearing account with your bank, the bank pays a small fraction of that interest to you and keeps a larger fraction for the bank's owners.

Through the magic of fractional reserve banking, people are able to borrow money that has not been saved by its owner. It's a kind of alchemy, seemingly generating something from nothing.

Some folks worry that money creation from thin air will ultimately lead to price inflation. If it does, then the counterfeiting we call fractional reserve banking turns into outright theft, since price inflation robs you, the original owner of the $1, of purchasing power. If you had saved a dollar in 1913, the year the Fed was created, today that dollar would purchase perhaps 9 cents worth of goods and services at today's prices. You might be forgiven if that loss of purchasing power seems to you a little like theft of 91 cents of your saved dollar.

When it is the federal government that borrows your $1, we get an even more insidious outcome. The federal government doesn't repay its debt, since it just creates additional debt to pay you back plus interest. Worse still, government acquires purchasing power over goods and services without taxing.  If government is building roads and protecting us from foreign despots, that's okay by me. But of course, federal spending isn't limited to road building and national defense.

Central banks around the world, especially the Fed, are making sure that the world is awash in money. But that money is not capital. It's just newly created claims over goods and services generated as if by magic from thin air.  Some believe that central banks around the world have built a house of cards. Let us hope that the wind does not blow too hard in the coming months.

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