“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” General Theory of Employment, Interest and Money, J.M. Keynes
Circulating Capital (Micro-Economics)
“From the point of view of the capitalist, the time of turnover of his capital is the time for which he must advance his capital in order to create surplus-value with it and receive it back in its original shape.” ——— Chapter 5, Book II, Das Capital, Karl Marx
Of the many facets of Capital, the most perplexing and misunderstood is the very medium through which capital formation happens, the mass of water that helps create a fountain or the blood that flows to help sustain a life are not really what they help to create or sustain and cannot be replaced for the other; wealth or net worth similarly cannot be replaced by the illusion of the creation of an asset without its contingent liabilities and thus the misplaced notion of circulating capital still abounds. In the current times this mass of circulating capital, by its presence, increment and depletion or sudden flight has plagued many an economy and the very nature of current market innovation in tuning the flow needs a careful scrutiny. But let us first have a look from the micro-economic standpoint.
The original reference to the term circulating capital came in Adam Smith’s Wealth of Nations, but Lord Macmillan gave a much better description in page 432 (Van den Berghs Ltd v Clark), “Circulating capital is capital which is turned over and in the process of being turned over yields profit or loss. Fixed capital is not involved directly in that process, and remains unaffected by it. If this is to be the test, I fail to see how the appellants could be said to have been engaged in turning over the asset which the agreements in question constituted. The agreements formed the fixed framework within which their circulating capital operated; they were not incidental to the working of their profit-making machine but were essential parts of the mechanism itself. They provided the means of making profits, but they themselves did not yield profits. The profits of the Appellants arose from manufacturing and dealing in margarine.”
Implicit in this reference is what Marx later proved in over hundred pages of his book two, that circulating capital is simply a vehicle through which surplus value is created; it by itself is not wealth or surplus value. To put it very succinctly by drawing from the pool of circulating capital or by enlarging this pool, we can neither create wealth nor destroy the same; the mere purpose is to act as a vehicle so that certain exchange of goods and services that is created by the use of it could bring about economic profits. To compute profits therefore it is necessary that such addition or withdrawal of circulating capital should be kept out of the purview, which in olden times created many a cause for claims that were erroneous. However it is to be noted that from the individual capitalist’s point of view he would have rather preferred to normalize all effects of such increase or decrease as the case may be to be able to see how he fared in generating certain level of profit at no change in circulating capital. No matter how desirable this case may be it is almost impossible to keep the quantum of circulating capital at the same level, given that it is dependent on a large number of factors like the level and cycle of production and sales, the ability of the business to be able to pay back in cycles to suppliers as desired by them and to be able to collect money in cycles from the customers, apart from the host of other factors which entails blockage of circulating capital for reasons that are exogenous or endogenous.
I want to highlight on the other hand that circulating capital does play an important role in a short term to influence the making of profits, as higher circulating capital while having its debilitating influence on interest payments has the more than positive offsetting effects in creating surplus value, as we shall see, only to be neutralized later when the flow has to be put back to the original state.
Let me take the example of a simple business that produces 100 items each at a cost $10 each (assuming that $8 is the variable cost per unit and total fixed cost is $200) let us have two scenarios, one in which a business produces 100 and sells 80 at a price of 12 each and in the other it produces 120 and sells 80 at a price of $12 each.
Case 1: Profit = Revenue – Cost = 80 x 12 – 80 x (8+200/100) = $160
Case 2: Profit = Revenue – cost = 80 x 12 – 80 x (8+ 200/120) = $187.2
The profit thus would go up, but at the cost of higher circulating capital, as the additional volume of production would entail higher buying of raw material and higher labor and other costs. So when the flow of circulating capital increases it could actually be used to generate short term higher profits.
The same situation would reverse when the production would go down by the same amount to square up the additional pieces that were unsold in the first case due to higher production. In this case the capital flow would revert back to the mean eventually if production is tuned to sales. There are some accounting methods that try to neutralize these effects, but no method can actually completely take all the effects out of the purview.
This is a simple example to demonstrate the influence of higher circulating capital in influencing a certain behavior of higher production but its impact is only for the term when unit costs came down because of such higher production and would eventually square up when the equivalence of production and sales is restored.
So we come to the first hypothesis that circulating capital, while influencing short term increase or decrease in wealth or profit cannot influence the overall increase or decrease of wealth in the condition where the quantum of circulating capital is eventually normalized and brought back to the condition as Marx wrote two hundred years ago, “receive it back in its original shape”.
This reference to circulating capital is important as the original thinkers of the likes of Adam Smith and Marx, did start off with this doubt that societies later could use circulating capital in more creative ways than was known in their times. I would move from Micro to the Macro-Economic framework where in an economy we shall examine how constant dosage of circulating capital or money spurs different sets of behavior for the businesses at different times.
Circulating Capital in the Macro-Economy
One would be in awe to see how enmeshed in an intertwined linkage, enhancement of business is overwhelmingly linked to the flow of money or the dosage of money which economists have evaluated in terms of its flow as termed as the velocity of money. Velocity of money has far reaching influence to serve as an economic engine for an economy as we shall see in a moment. But first we shall cover the Quantity theory of Money in a very terse form.
Let us start with the fundamental question what drives the demand for money? For goods and services to be bought and sold we need money and the demand is driven by the average price level in the economy. If the average price level goes up more money is in demand and vice versa, the point to be noted is that when the average price level goes up the value of money actually comes down and this is offset by the higher supply of money. We need to also remember that the consumers create the demand by their need of money to purchase and sell goods and services, whereas the supply of money is done by the Central Bank and the balancing factor is the price level in the economy, which can be called as the equilibrium price level or the equilibrium value of money. Here we must also note that any change in the price level creates an equal and opposite change in the value of money. So by all means it would be simple to infer that if the central bank increases the supply of money the value of money will fall and the price level would increase.
However we need to introduce the parameter, the velocity of money to understand the situation a bit better. Velocity is defined at the rate at which money changes hands, so to put it very simply if there are two constituents in the economy, that is one buyer and one seller, and if the exchange is even, then the money will change hands only once if there is one transaction in a given period. So the velocity would be one. This is the lowest velocity that we can think off and on the other hand the highest amount of money that would be needed for a single transaction. Whereas if the money changed hands quickly or if the turnover rate would have been higher, then even with a relatively small quantity of money a higher rate of economic activity could have been done as higher purchases or sales could have been done in the same period.
Velocity is never constant and is dependent on a number of factors; the most significant is the value of money and the price level. If the price level shifts and the same supply of money is kept then the velocity must change to counteract. Also if the money supply shifts then the velocity must also adjust itself. The relationship is simply put as M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can be rearranged as V = (nominal GDP) / M. This means for the same level of economic output, with higher money supply the velocity of money must come down. Or to put it differently if the money does not change hands quickly the supply of money must go up to bring in the same level of output. Conversely it is also true that to make the money change hands quickly the supply of money must come down for the same level of output.
Quantity Theory of Money & Short Run Vs the Long Run
In the short run, the velocity could change, as with preferences or with economic activities being in the ramp up or ramp down and sometimes the central bank targets certain objectives to be attained in the short run, inflation or price level or spurring the output are few of the important ones. Velocity largely remains the same as it is very difficult to change the basic habits of consumers; however Paul Samuelson is of the view “In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.” Page 354, Economics
Let us try to imagine a situation as the current one in which we have a dampened output in the economy and the price level is also low and there is a lot of unutilized capacity in the system. So we have V = Nominal GDP / M and given that the primary purpose is to increase the output, the central Bank increases the supply of money, so if the Velocity remained constant as per the quantity theory of money, then with an increased supply the output should have gone up. How does this work in the real economy? More money is available in the hands of business to invest and at a lower cost and this spurs economic activities in all forms. But remember we have a low price level and a lot of unused capacity, so the price level to go up takes time and therefore inflation does not happen that quickly.
But the more important question is the one asked by Samuelson, does the supply by itself create new economic activities or in other words new jobs, which would mean that velocity remaining constant the output would naturally go up? This question needs to be seen in the light of the latest data on job creation. If we take the U.S. economy as a test case the increased money supply by the Fed, which stands at over $1 Trillion in the past two years, has not created new jobs at a rate that we should have expected. In fact the reverse has happened that the increased money supply has gone into higher savings rate at the corporate level, which is clear from the corporate savings glut data as shown below and it has a direct positive correlation with the rate of unemployment. This is exactly what Samuelson has questioned while on the same topic that merely the increased money supply does not by itself create higher output, wealth, jobs, etc. This is simply because the velocity in the short run adjusts itself downward if adequate incentives for spurring growth or jobs are not prevalent in the economy. This is actually well in evidence in the case of another economy China, where with increased money supply just after the crisis, the economic output could be raised and is a pointer that for velocity to remain constant we must have other leading indicators of the economy to support higher output or have concurrently suitable incentives to the creation of jobs.
I do not have the same chart for China, but it is only to be expected that the chart would look quite different as corporate savings is equivalent to State savings which is balanced by investment in the domestic sector in a host of employment generation initiatives. But let us go back to the fundamental question whether money supply by itself can create wealth or higher output and if it does then what are the underlying conditions.
This chart above, I would argue is another demonstration that the excess supply of money by the central bank is hoarded away by the corporate into liquid deposits that are doing everything other than creating employment, or in other words the primary purpose of increased money supply is lost. The point to be noted also is that the increase in M2 exactly equals the corporate savings glut, which means that the money supply actually remains unchanged if this unproductive component is taken out. On the other hand if this component was zero it would have meant money was actually in circulation in form of economic investments rather than financial as the case actually is.
We need to delve deeper into the questions of use of money in economic activities and the drivers of human preferences that at times makes him part with money while on the other situation influence him to hold or hoard for a better prospective denouement for the latter time period. This apparent human tendency to hold or to part in some way influences the economic activities of the short term. This when looked at over a really longer term does not give the same set of inferences.
Liquidity in a speculative scenario
Keynes in his immortal book, The General Theory of Employment, Interest and Money, has delved into the important questions of human preferences as regards money in his important observation on Interest, “The inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time” [Keynes, 1964, p. 167]. He adds later that it is “the reward for parting with liquidity” [Keynes, 1964, p. 167]. This would take us to the inference that interest is “the ‘price’ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash” [Keynes, 1964, p. 167]. This desire is “liquidity preference,” which is “substantially the same thing” as “propensity to hoard”–as long as that is not confused with “hoarding” [Keynes, 1964, p. 174].
We are here dealing with two very important aspects of money, its ability to influence decision making in terms of it being held or parted for spurring any economic activity, and the second that we introduce an incentive, in form of interest to either allure him or drive him away from his desire to part or hold; both these aspects play havoc as we shall see in terms of spurring demand or economic activities in the short run.
First of all let me go back to the original situation I had described that an economy has unused capacity and has prices that are lower and the central bank introduces a dosage of money supply. If we see after a year or two that there is more money saved then it is clearly an indication that the interest rate as a reward to part with liquidity is too low. It is indeed at its all time low and thus it is actually acting as a driver for too high liquidity in the economy. Does this mean we have a very urgent need to have too high liquidity in the economy? Yes, for a very short time, just as the crisis struck there was a very urgent need to infuse liquidity in the economy, especially in the light of the bank runs that took out quite a chunk of money supply from the market. But to continue with higher dosage of money supply must have other reasons than the sole purpose of liquidity.
Keynes referred to three situations of liquidity preference, L1 = Transaction Motive, L2= Precautionary Motive, and L3= Speculative Motive. He went on to explain that there are also two different functions one which depends on the level of income and the other which has a correlation between the level of interest and the future expectation.
What then is the reason for holding on to too much cash? This question needs to be seen in the light of what liquidity does in a speculative scenario. To understand this we have to again go back to Keynes and his Chapter 17 (The Essential Properties of Interest and Money) gives an excellent summary of what constitutes the return on different classes of assets, and in today’s world we cannot disregard the fact that financial assets form a significant chunk of assets that could give returns that would be almost impossible to be attained from any other class of asset under certain conditions. Keynes at the beginning of Chapter 17 had provided us the clue that various classes attract various rates of interest (which he referred as the commodity rates of interest) as the expected return or the “liquidity parting attributes” are different. He writes later:
“There are three attributes which different types of assets possess in different degrees; namely, as follows:
(i) Some assets produce a yield or output q, measured in terms of themselves, by assisting some process of production or supplying services to a consumer.
(ii) Most assets, except money, suffer some wastage or involve some cost through the mere passage of time (apart from any change in their relative value), irrespective of their being used to produce a yield; i.e. they involve a carrying cost c measured in terms of themselves. It does not matter for our present purpose exactly where we draw the line between the costs which we deduct before calculating q and those which we include in c, since in what follows we shall be exclusively concerned with q – c.
(iii) Finally, the power of disposal over an asset during a period may offer a potential convenience or security, which is not equal for assets of different kinds, though the assets themselves are of equal initial value. There is, so to speak, nothing to show for this at the end of the period in the shape of output; yet it is something for which people are ready to pay something. The amount (measured in terms of itself) which they are willing to pay for the potential convenience or security given by this power of disposal (exclusive of yield or carrying cost attaching to the asset), we shall call its liquidity-premium l.
It follows that the total return expected from the ownership of an asset over a period is equal to its yield minus its carrying cost plus its liquidity-premium, i.e. to q – c + l. That is to say, q – c + l is the own-rate of interest of any commodity, where q, c and l are measured in terms of itself as the standard.”
Keynes gives examples of various asset classes like the “Consumption Capital” of a House, or the “Instrumental Capital” of a Machine, to argue that the yield q-c is positive and c is almost negligible as the ‘power of disposal’ is very weak.
For money on the other hand while its yield being nil, its carrying cost negligible, its liquidity premium is very high. So for Money:
Total Return for Money = 0 – c + l or l – c is actually quite a positive number, at least for now, which is greater than the return on a Consumption capital like a house or the Instrumental capital like a Machine in today’s economy, otherwise there is little reason for Money as an asset class could be ‘hoarded’.
So we have a question that between the different classes of assets while the rate of interest is guided by the total return in monetary terms, for money itself as a standard, this works differently.
Here we need to introduce the marginal efficiency of capital or of the different asset classes in monetary terms, which according to Keynes on page 135 has been given as, “the rate of discount which would make the present value of the series of annuities given by the returns expected from thecapital asset during its life just equal its supply price”.
Consider the current scenario of an economy where the signs are not clear either in terms of sustainable housing recovery or of employment or of businesses investing in their own economy other than some very special sectors, what would the general body of businesses do in terms of the use of money?
It has three options, invest in capital assets, invest in financial assets or wait for signs that would make it abundantly clear in which direction the overall economy could be headed. The three options would have three different total return scenarios as the R = q – c + l would be different in the three different scenarios.
But if we look at the first one, investment in capital assets, it would clearly be the riskiest of the three, while the hoarding of cash the least risky, but the return would depend on how the rest of the economy actually performs.
I find this quite odd and almost like a circular argument that the very engines of economic growth are waiting for the economy to lead them, it is almost like the horse waiting for the cart to pull it. It is actually in the first asset class of capital investments that the economy is waiting to catch on as it is only in this asset class where job growth can happen, as it is currently difficult to create a job growth in the second, which is the financial asset.
But once again I question the basic rationale for so choosing the riskless class of cash as an asset class for its liquidity premium, in a world of enterprise that is waiting for the true signs of recovery that it is supposed to drive? The answer again lies in the understanding of the true liabilities that these classes of assets create and how these liabilities come in direct conflict with the incentives that drive objective behavior in these enterprises. I would take the help of Minsky from his immortal book John Maynard Keynes (Pages 70 & 71), where he writes while explaining the role of money, “In a world with private financial liabilities which are used to acquire control or ownership of assets, these financial liabilities are what “buys” capital assets. The holder of a bank deposit is indirectly financing some position in capital assets. These private financial liabilities set up cash flow commitments. The cash to meet the liabilities of households and business firms will ordinarily flow from their income producing operations, as wages, sales proceeds or gross profits. The possession of money- and of financial assets that are near monies, i.e., savings accounts, certificates of deposits, etc. – acts as insurance against the economy, or particular markets, behaving in an inappropriate way; that is , in such a way that cash flows from operations or the ability to raise cash by financial transactions are insufficient to meet needs. In addition, the economy contains financial units such as banks and insurance companies, whose normal functioning requires that they receive cash both as the terms of the financial contracts they own are fulfilled and from the sale, in well-behaved financial markets, of owned financial assets or of their own newly created liabilities. For such financial units, just as for households and firms, the possession of cash acts as insurance against shortfalls in cash receipts due to either defaults on contracts owned or malfunctioning of the financial markets on which they sell assets or borrow.”
When cash is set aside for the purpose of everything other than committing to an asset class which would entail immediate inception of conterminous liabilities or claims by other stakeholders, it could mean that one section of the society, which is the financial institution, is pitted against another section, the business institution, in an exchange where the latter as holder of assets (cash) do not want to commit to liabilities and the former who are left with less assets (cash) have to look for constant means to serve this vacuum. In a normal economy this situation is abnormal as the absence of a normal “turning over” mechanism in the real economy has far reaching implications. This situation of high liquidity (the entire stock market is the biggest liquidity provider but at the same instant the biggest impediment to the turning over mechanism that the normal economic activities would have ordained) also serves the purpose of speculative investments that could generate short term gains for some while equal losses for the other, unless there is a contagion that spurs constant creation of bubble in the price of the asset class. The buy-back of shares that acts for the purpose of increasing earnings per share which is the key statistic for stock price appreciation is one of best use of cash by corporate, which is again not a very good driver of economic activities in any economy. Such and other such uses of cash precludes high holding of cash and setting aside of cash from real capital investments. High liquidity for a protracted period is the start of this contagion to begin acting towards the objective of a speculative bubble, which Keynes had referred to in his warning as highlighted at the very start of this essay; this is all the more the reason that liquidity premium of cash as an asset in the current times have increased many folds. The quick “power of dismissal” of this asset class and “quick acquisition” makes it a formidable tool in the speculative world of wealth creation.
Completed on 25th March 2011, Zurich