ACE 2006:  Capital, Asset & Finance Markets

Given that markets for goods and services operate largely as does competition and natural selection in natural evolution - except that in socio-economic evolution, the criteria for social and economic selection and persistence are internal and endogenous rather than god-given (given outside determinants) as the laws of bio-physics (external and exogenous) - how do capital and finance markets fit the picture?  What are the natural counterparts or analogues of capital? 

The short answer is that there are none - the natural world does NOT 'own' or accumulate assets (aside from a bit of nut hoarding by squirrels etc., and some limited boundary protection activity).  Capital, capitalism and finance markets are socially constructed human inventions - and, as a consequence, need to be 'governed' somehow - the socio-economic (and hence political) rules and codes for persistence and selection are necessarily endogenous and internal.  Goods and services markets embody the internal selection criteria through consumers - the consumer is (ultimately) sovereign, and determines who succeeds and who doesn't, and hence continually re-generates the incomes which drive consumption through the circular flow of income.  What about capital and finance markets?  Who (or what) drives, sanctions and legitimises these markets?

First, how did they evolve?  Goods and services 'markets' first emerged as barter - I will give you food if you give me shelter - which allows specialistation and (at least implicitly) trade.  But the scope of this is pretty limited.  Barter became seriously lubricated and dramatically extended with the invention of money - a commonly accepted and trusted medium of exchange which could 'stand in for' the equivalent amount of any good or service (and hence allowed for and required the articulation of a price for each good and service as the amount of the common numeraire - money - which a unit of the good or service commanded). -> whatever is used as money, it had better be: convenient and easy to use, carry, store (and so be durable/hard-wearing) etc.; difficult/impossible to counterfeit; and so be reliable - if anyone/everyone can 'print' their own, they will and the 'money' will quickly become useless - the rules (properties of money, in this case) have to be made by people and their governers and stuck to for socio-evolution to be sustainable.  Money is a fundamental and archetypical exhibition of the endogeneity of the selection criteria in socio-economic evolution: if we cease to believe in it, it ceases to work; if we worship it, we get what we deserve.

Once trade and exchange develop through the lubricant of a reliable money, so promisory notes and bills of exchange become commonplace (identifying transactions (exchanges of ownership) of particular commodities or services).  Ownership of these bills and notes become pretty well as good as the ownership of the goods, commodities and services.  They are almost as good as money, and indeed discount houses quickly establish as businesses which will exchange these bills and promisory notes for money (bank notes and coin).  Meanwhile, banks (storehouses and safekeepers of assets) have long been around - exploiting economies of scale and of specialist knowledge, reputation, equipment, buildings, and skills.  Discount houses can rather quickly become banks for money - the founders of most of British banking grew from discount houses, while the founders of Italian banks grew from the storage of the valuables of pilgrims.  Banks rather quickly learn that depositors seldom all return and require their money or assets back all at once, so banks put their customers' stores of wealth to use by lending it out to others. They can 'lever' more lending by encouraging depositors to guarantee that they will not require repayment (reimbursment) within a given period of time by offering interest on the deposits (paid for by the interest the banks charge on their loans to debtors).  Banks rely on the trust of their depositors that their money (wealth) is safe with the bank - if, for any reason, depositors become nervous that their money might not be safe, they will rush to get it back before it is too late - a run on the bank, which can quickly bankrupt the bank, and 'destroying' the wealth of the depositors. Hence, bankers need to be fundamentally prudent - taking care to ensure that their debtors can and do at least pay the interest on their loans, and, if not, actually have some assets (collateral) which will serve to discharge the loan - forcing the threat of bankruptcy back up the chain to the banks' debtors (those who have bank loans).  Nevertheless, the attraction of banking as an easy way to make money encourages greed and lack of prudence - the results of which can give banking as a whole a bad name. So, commercial banks become 'regulated' - licenced and guaranteed by the central authorities (the central (national) bank - the Bank of England), which insures banks against runs (lack of liquidity) by providing reserve funds, in return for undertakings of the commercial banks to behave prudently and maintain their own capital reserves at a reasonable level.

Citizens need to store their wealth (save) for their old age (pensions) and against unforseen circumstances (insurance) - precuationary saving is what most of us do most of the time. We require that our options for doing so are secure (wealth will not lose its value, ideally, increase in value). Pension funds and insurance companies, both mutual (cooperative) and commercial (for 'profit' - as a measn of earning a living) necessarily emerge to provide these services.  All of these organisations (banks, pension funds and insurance companies) are responsible (or not) for looking after peoples' and businesses') savings, and compete to do so most effectively so as to attract savings (albeit that the information required by the savings customer (creditor) is especially difficult to identify and interpret, meaning that the competition for storage and security of savings is likely to be imperfect at best).

On the other side of these financial markets are the borrowers (debtors) who want to borrow against either collateral or future earning prospects to make real investments (in machinery, plant, equipment, new buildings, human skills etc) in productive capital (as physical, productive assets). In addition to private individuals and companies, governments also need to borrow money to bridge the difference between tax (and other government revenues) and expenditures (including those on physical, human and social capital - 'genuine' investment) - and issue bonds (government i.o.u) to do so, selling these gilt edged securities to banks etc. in return for the loan, and paying fixed rates of return on the face value of the bond in return).  Similarly, corporate business discovers the advantages of the limited liability company, and issue shares in the company's total value (it's stock) - which grants shares in the company’s profits (and losses) to a number of (perhaps distant and rather disconnected) people, in order to access a greater volume of investment (speculative) finance necessary to operate the business.  Bonds and shares become traded in the stock and finance markets.  But these stock markets are fundamentally different from those we have been dealing with for goods and services (which are markets for flows of production and consumption).

In effect, we have three conceptually seperate but highly inter-related finance and asset markets:  1; the market for money itself;  2 the markets in which savings (loanable funds) are matched with real (physical and human capital) investment opportunities; 3 stock markets, which simply exchange the ownership of claims on real economic activity.

1.    The Market for Money (Money market)

Money is used both as a medium of exchange for transactions (active bank balances) and also as a store of wealth (idle bank balances).

Demand for and Supply of Money:  The price of money is the interest rate (what it costs to get more of it!)

2.    Capital Markets:  Balance between Savings and Investment (in new plant and equipment etc.)

The rate of interest also influences Savings and Investment - the balance in the capital market for loanable (investment) funds
Notice: If the interest rate (set in the money market) results in I > S, then there will be a tendency for the level of National Income (Y) to grow - increasing savings (shifting this ceteris paribusSavings supply curve shifts to the right as incomes increase) to match the additional investment.  However, increasing Y might also increase Imports and Taxes - so that the imbalance between savings and investment might persist - offset by imbalances between G and T, and between IM and X. - from the Circular Flow of Income and the necessary balance of funds.






 
 

3.    Financial and Asset Markets - who owns what bits of existing capital.

The Stock Market: where already existing shares are swapped between people who want more (buyers) and people who want to hold fewer shares (the sellers). The total stock of shares is pretty well fixed (aside from occasional new issues).

The land market:  The total stock of land is Qf. Whatever the price, this total stock cannot be changed (aside from minor changes like draining lakes etc.) The sellers are signalling a negative demand for the thing (land in this case) - the offer curve (Oc) - the higher the price, the greater the quantity we might expect present owners to be willing to sell. By the same token, all present owners who are not selling are exhibiting a positive demand for their stock given present prices. This positve demand is labelled the reservation demand (RD) in the above figure, which is the mirror image of the offer curve (Oc). What is not being offered for sale by present owners is being retained (held onto) - that is, it is being demanded.
The excess demand curve (XD) shows how much more land present owners and non owners want to own at each price - more is demanded over and above present holdings of land as the price falls.
The horizontal sum of the reservation demand (RD) and the excess demand (XD) is the total demand (TD) for land, or stock. It is the intersection of this total demand (TD)with the fixed supply (Sf) which determines the market price for land (Pe).

The trades we observe in a stock market are those between people who no longer want to own the stock, for whatever reason, shown by the offer curve (Oc) and those who want to own more than they presently have (which might be some or none at all) - shown by the demand for additional stock (excess demand) labelled XD above.  Offer and XD intersect at the trading price (Pe) and Qt of land (or stocks and shares) change hands between buyers and sellers.

When all these trades have been made,  the present owners are now willing to go on owning land at the present price, and are not willing to sell any.

Share Prices and Stock Market price movements.
So, what is a stock or share (or piece of land) worth?  The simple answer first - it is worth whatever someone else will pay for it.  The current market price of the share, or piece of land, or any other physical asset, is as good an estimate of what it is worth as you can get.  The current price reflects the total demand (reservation and excess demand) matched with the fixed available supply.  The price will change, as in all markets, only if demand shifts or supply shifts. For land and stock markets, the shifts in total supply are usually pretty trivial compared with the total stock.  So it is shifts in demand which are critical in determining prices in these stock markets.

What will shift the demand curve for land (or stocks and shares) and hence change their prices?

The two values are related because the market price can be interpreted as the market buyers expectations of future earnings or returns. The key relationships can be illustrated through this perpetual asset: PV = R/i = Market Price of the asset: So, if a particular company discovers a new recipe for making profits, its annual returns (R) will be expected to increase, and its share price will increase until the internal rate of return falls back in line with the market rate of interest - given the risk and inflation element of the company.  Conversely, if the company falls on hard times, because its market is shrinking or because it is being badly managed, its returns will fall and its share price will fall as well, until the internal rate of return is once more in line with the market rate.

Suppose we do not expect rents to remain constant in the future.  What might they do?  They might be expected to increase (or fall) by some average and constant amount each year (say plus or minus £A per year).  In this case, the relevant sum for the present value of this stream of future rents (annual returns) becomes:
 PV = R/i + A/i2 , where R is the basic rent or annual return (expected this year) and A is the amount by which we expect this annual return to change each year in the future, and i is the discount rate (the opportunity cost of capital - what we could earn elsewhere, investing in something else).  So, if we expect returns to fall, the present value is reduced compared with the simple sum which assumes the return stays constant.  But, if we expect returns to increase, then the present value increases, too.

Or, we might expect a continual percentage change in the annual return, say plus or minus g% per year.  In this case, the PV sum becomes:
PV = R/(i - g), so that, if the expected growth rate (g) in the returns on this asset are higher than the opportunity cost of capital (i), the present value for this asset goes to infinity: there is no price it is not worth paying for such an asset - which is an explanation of why share prices shoot upwards for companies expected to do very well in the future.

Depreciating assets - ones that wear out.
So, how do we account for the fact that physical plant and equipment wears out and becomes obsolete?  By making an allowance for the depreciation of the asset - the continual re-investment necessary to maintain it in a non-depreciating state.  Suppose that this depreciation rate is d%.  The gross return we need to get from this asset needs to cover this depreciation rate, so the net return we need to get on any depreciating asset is the gross return minus the estimated depreciation rate.  So, the gross return we expect to get should be i = r + p + u + d on these assets.

So what for the agricultural land market?

4.   For some further (verbal/qualitative) analysis of this complexity and its implications see: "Is Economics part of the problem? An incomplete review" (paper by DRH to a recent conference, Prague, Sept. 2011)

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