Friday, 7 June 2013

The Circuits Of Money and Capital - Part 2

The Flow Of Money and Fictitious Capital

Here I want to look at the money flows into Share Capital, and Bonds etc. (which includes also property, art and other forms of speculation), i.e. fictitious capital.

I will start by looking at share capital. It will be seen that share capital also has a dotted line connecting it to K, the productive capital. This is to indicate that there is an indirect link between the value of share capital, and the value of the underlying productive-capital. It is only an indirect link, precisely because, although the value of the productive-capital is objectively determinable, the value of the share capital is not. The value of a lathe, or a factory is objectively determinable, in the same was as for any other commodity. But, the value of shares moves up and down, by the millisecond, as a consequence of billions of shares being bought and sold by computers.

Share capital is, in theory, a share of the actual productive-capital of the firm, equal to the mount the firm borrows by the issue of shares, to be able to purchase the productive-capital, but in reality, the value of that share capital is measured not by its capital-value, but by its potential profitability, i.e. what rate of return it is likely to bring. Moreover, Marx points out that, even during the 19th century, capital had developed to the stage where the capitalist was no longer the entrepreneur. That role had been taken over by the professional manager. The function of the actual capitalist was now simply the provider of money capital. The modern day capitalist is precisely that, especially where that capitalist is a collective capitalist, in the form of a bank, insurance company, or pension fund. There is no longer any tie, or link, to the particular firm, to which money-capital is provided, and the concern is no longer, necessarily, with maximising the rate of profit of productive-capital, but only maximising the total return on money, which may or may not be invested as money-capital. In fact, a maximisation of the rate of industrial profit, may be of little concern for speculative money capitalists seeking to make quick capital gains, rather than long-term income.

The only direct link, between share capital and productive-capital, is where a public offering of shares is used as a means of providing money-capital, with which to buy productive-capital. But, the diagram is still correct in this regard. The money spent by investors/speculators to purchase such shares comes from, and goes into Bank Deposits as money not capital, and flows out of it to the company, which issues shares in exchange. So, the money flows out of bank deposits, not as money, but as money-capital destined to purchase productive-capital. The nature of the indirect link between share capital and productive-capital is again highlighted here, and is significant.

The more shares a company issues, the lower tends to be the price of each share, simply because each individual share represents a smaller share of the underlying productive-capital. When companies issue additional shares – for example, through a “Rights Issue”, where existing shareholders get the right to buy additional shares in some determined proportion to their existing shares – this dilutes the existing share value, causing the prices of the shares to fall.

The reason this is important at the present time, is because of the effect I have written about elsewhere in relation to interest rates. When the rate of profit is high, the supply of new capital relative to the demand for capital tends to be high. Companies can generate funds for their own expansion easily from their own profits. So, they will tend to issue fewer new shares, or bonds to raise additional capital. Interest rates will fall, as will the dividend yield on the shares.  That together with the increased profitability will mean that share prices tend to rise. The demand for shares rises, because anticipated future earnings from them rises, whilst the supply of new shares fails to rise to meet that demand. During such periods, there also then tends to be a “re-rating” of shares i.e. the price-earnings ratio expands. The p/e ratio is the measure of the price of a share against the amount of profit made by the company per share.  On the other hand, the increased rate of profit, can also then lead to firms seeking to expand faster to take advantage of an expanding market and profits.  If this leads to the demand for capital rising faster than the supply of new capital from profits, then interest rates will rise, firms will issue more shares and bonds in order to borrow.  Share and bond prices will fall, yields will rise.

Over the last period, what has also been seen is that with surplus cash, many companies have not only failed to issue new shares, but they have used company funds to buy back existing shares. In fact, with very low interest rates, many large companies have even borrowed money in order to use it to buy back shares. By reducing the number of shares in circulation, this automatically increases the amount of profit per share, thereby making the existing price-earnings ratio look lower than it otherwise would be. In fact, new share issuance in recent years has been at record lows, whilst the amount of share buybacks has been at record highs. When, market analysts talk about existing p/e ratios, therefore, not being extended, in order to justify bullish comments, about the possibility of share prices continuing to rise, this gives a very distorted picture of the underlying reality.

The important thing to remember about share capital is that it is not, as many bourgeois apologists try to portray it, a measure of financing of productive activity. The amount of financing of new productive-capital, done via the issuing of new shares is minimal, compared to the volume and value of shares traded on stock markets. A look at most Initial Public Offerings of shares is an indication of that. Most companies, like for instance, Facebook or Google, were trading long before their shares were listed on the Stock Exchange. Stock Exchanges, in the main, exist only for the existing owners of shares to exchange them one with another. When the price of Google shares rises, for instance, this does not directly benefit Google. It is not money going to Google. It only means that the owners of Google shares can sell those shares for more money than they could have done previously.

On the other hand, there is more of a link, between the productive-capital and share capital, than there is between say productive-capital, and commercial bonds, issued as a means of raising capital. If companies' profits are rising, share prices will tend to rise with them, and vice versa. But, a bond, once issued, will continue to pay interest, at the specified rate, whatever happens to the company's profits. The value of the bond may rise or fall, on the secondary market, but, if held to maturity, will still repay its face value.

That brings us to bonds, which can be commercial bonds, as above, or Government Bonds, or Municipal Bonds. Once again, what buys these Bonds is money not money capital. The money only becomes money-capital, when it flows out of Bank Deposits, to be used to buy productive-capital. So, for example, as stated above, a company might take advantage of low interest rates to issue bonds, and then use the proceeds not to invest in productive-capital, but only to buy back existing shares. That would not constitute a capital flow, but only a flow of money.

As Marx points out, neither shares nor bonds constitute capital. They only represent a claim to assets, or to future income, i.e. a claim to a share of future production. They are fictitious capital. Unlike, the productive-capital, or indeed the commodity-capital, whose value can be objectively determined, there is no objective basis for determining their value, which is why they are prone to speculation. A common dictum of traders be they of shares, bonds or commodities is “The trend is your friend”. In other words, if the price of some share etc. is rising in a trend, the safest bet is to buy it on the expectation the trend will continue. That is particularly, true where there is momentum trading, where large amounts of demand for a particular share or asset class, causes its price to keep rising. But, there may be nothing material underlying such a trend, which simply then results in an asset price bubble, which collapses far more quickly than it took to inflate.

The more money exists within the system, with less of it being demanded for use as productive-capital, the greater is the potential for money to flow into this kind of speculation. Unfortunately, where such speculative periods exist, they can also crowd out demand for real productive purposes. If capitalists see the potential for buying shares or bonds that might rise by 50% in a year, there is less incentive to use that money as money-capital, to purchase productive-capital. That has been one of the problems facing US, UK and European economies over recent years, largely caused by the intervention of central banks and governments to underwrite such activities.

Its notable that one of the fastest growing economies on the planet is China, and yet one of the worst performing stock markets on the planet is also China. It has gone almost nowhere, and part of the reason for that is that the vast amounts of surplus value produced in China have been reinvested in productive-capital rather than buying shares and bonds. In fact, where they have gone into such purchases, they have largely been of those in western economies.

The other main class of “assets” included under Bonds etc. is property. In reality, most property should not be considered in this way at all, but should be considered no differently than any other such commodity, like a car or a washing machine. Like those other commodities, the value of a house is objectively determinable by its Price of Production. But, any commodity can be made the object of speculation, particularly where its supply cannot be easily and quickly expanded. In the 17th century it was tulips, for example – Tulipomania. In those cases, the market price can be driven up way beyond any rational measure, let alone the price of production.

I have set out in many other posts the extent to which property prices have been driven up into a massively inflated bubble, so I will not repeat that here. Suffice it to say that according to the IMF and OECD, UK property prices are estimated at 40% above their long-term average. All such bubbles eventually burst and when they do, prices always overshoot in the other direction. Similar property bubbles in the US and Ireland have burst with prices falling by up to 70% in places. In the US, however, there is evidence that continued low interest rates and money printing is creating a secondary bubble with property prices rising by around 10% p.a., driven mostly by speculative buying rather than buying by actual home buyers. Even in Germany, which has usually escaped property bubbles, because of the high level of renting, there are signs that money searching for a home has started to blow up a property bubble there.

The point about these money flows is that they can continue to circulate within their own domain, blowing up such bubbles, and separated from the circuit of capital, and of commodities for some time. That is particularly true given the role of credit.

The value of commodities, including capital can be objectively determined, but the value of shares, bonds etc. contains a sizeable subjective element. Speculators buy a share on what are largely subjective grounds e.g. an expectation that the company's profits will rise, or that the share price itself might rise. The same is true of bonds, or art, or wine, or gold bought for speculative purposes. The same thing can be true of property. In conditions where its thought that the price of property will continue to rise, and interest rates and lending conditions make it possible for people to buy, few potential house buyers will give much consideration to whether the price they are paying for a house has any kind of rational foundation. The main consideration will be a concern to “get on to the housing ladder”, before prices rise further. Even when prices are falling, they may have to fall hard and for a prolonged period, before this enters the general psyche, that house prices can go down, and that a decision to purchase should be based upon whether what is being bought offers real value or not.

Where money flows within this circuit of money, it can act to blow up such bubbles very easily, precisely because of this subjective element. If A owns a share in Microsoft, B owns a share in Apple, C a share in Google each with an initial value of $100, then A can sell their share for $200, provided, for example, its bought by B, who sells their Apple share to C for $200, who sells their Google share to A for $200. No additional money had to be thrown into the circuit to effect these purchases, because all that really happened is the price tag on each share was changed, and the ownership of those shares was simply rotated.

Not one iota of additional value was created by these transactions, only $300 of fictitious capital. Its truly fictitious nature is illustrated by what happens if the money tied up within this circuit begins to leave it. Not only can money prices of shares, bonds, property etc. be inflated by the price tag simply being adjusted within the asset class, as money flows from one share to another, one bond to another, one house to another, but that process can occur as a consequence of money flows from one asset class to another. In recent months, there has been discussion of “The Great Rotation”. That is a move of money out of bonds, and into shares. The basis of the idea is that bond prices are at several century highs, and its thought that QE will end, and interest rates begin to rise. But, this is still a movement of money within this circuit of money, within the realm of financial assets. It is no different from a situation where certain classes of shares might fall, whilst others rise.

What has been unusual about the situation existing over the last 30 years, is that all these asset classes have risen. The prices of houses have been inflated, and on the back of that, banks were enabled to lend more money, using these inflated prices as collateral. The additional money could then flow into shares, for example, pushing share prices higher overall. Moreover, the fact that over the last 30 years, the rate of profit has been rising, means that the supply of capital relative to demand was high, providing the basis of low interest rates. That led to a thirty year bull market in bonds that appears now to have ended.

But, when money flows out of this circuit entirely the consequences for these financial assets can be catastrophic. If the demand for capital rises relative to supply, interest rates rise. As I demonstrated recently, this demand for capital cannot be dealt with via money printing, precisely because money is not capital. The demand for capital, as Marx sets out, must first assume the form of a demand for money-capital in the money market. This is true even if firms use internally generated surplus value to finance a greater portion of their capital needs, a smaller portion then being available for distribution as dividends etc.

Firms then begin to issue more bonds, thereby lowering their price, and causing interest rates to rise. They borrow more from the bank with the same effect, or else they issue additional shares. In the last case, the additional shares dilute the share value of the individual firm's shares, but it also means that an additional supply of shares exists in the market overall to soak up investors/speculators funds, thereby putting downward pressure on share prices in total. Once markets begin to move in a downward direction for any prolonged period under such conditions, the same kind of mentality of “The trend is your friend”, can then operate in the opposite direction. Momentum trading can send share prices sharply lower. The collateral they represented on banks' balance sheets becomes drastically undermined, meaning they have to curtail lending to comply with capital adequacy limits.

But, the effect of rising interest rates affects all of these financial assets. When bond yields rise this also puts downward pressure on share prices, because shares then have to offer investors a higher return for the higher risk they represent, and because higher interest rates mean that less money is likely to be available out of profits to distribute to shareholders. But, in conditions of a huge housing bubble, they will have a much more pronounced effect on property prices. There is considerable evidence that a majority of home buyers are struggling to meet their payments even with such historically low interest rates. Outside London, house prices are already falling, and demand is non-existent. As interest rates rise, the number of defaults will rise, the number of forced sales will rise, and despite the Governments schemes to promote additional debt, fewer people will be able to afford to buy. Property prices will have to collapse, but that again impacts banks' balance sheets, once again leading them to curtail lending. That in turn leads to limitations on lending to zombie companies.

The basis of this collapse of financial asset prices is that money leaves this circuit in order to enter the circuit of capital, or at least remains in the circuit of capital rather than leaking into the circuit of money. Although this can appear catastrophic, for the reasons I have set out elsewhere - What Happens If Greece Defaults – in fact, both for workers, and for big industrial capital, it can be quite the reverse.

Take the removal of funding to zombie companies. In fact, that means that money going down the drain to these companies becomes available for better use. As the zombie companies go bust, their capital is bought on the cheap by bigger, more efficient companies, raising their rate of profit, and providing a more rational basis for the use of the capital, including the ability to employ workers on higher wages and with better conditions.

A collapse in house prices means that workers can buy them where currently they cannot, and in any case, it means an overall reduction in workers housing costs, thereby providing the basis both for an increase in workers real living standards, and a reduction in the value of labour-power, thereby raising relative surplus value. It provides the basis for a further accumulation of capital, raising employment levels.

If bond and share prices fall, workers pension contributions go much further. If the average price of a share is £5, then a workers' pension contribution of £100 a month will buy 20 shares a month, 240 per year. If the average dividend on that share is £0.50, this provides a potential income out of which to pay a pension of £120. However, if the average share price falls to £2, the worker's £100 a month contribution will buy 50 shares a month, 600 a year. The fall in the share price has no effect on how much profit the firm makes, and so it should continue to pay £0.50 per share in dividends. That means £300 becomes available out of which to pay future pensions, an increase of 250%!

The other aspect of these money flows is their use for the purchase of commodities, including the use of credit for that purpose. I will examine that in Part 3.

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