Originally Posted by Kurt Horner

Assumption, and not a very reasonable one either. In a world without patents all you need to do to find out your competitors process is to hire one of their engineers.

Generally you have your engineers sign nondisclosure agreements as a condition of employment (I did).

All of these examples come from an industry where patents are a major part of the typical business model.

No. Trade secrets are more important. Patents promote the spread of technology. Patents provide short term protection in exchange for disclosure. For example, a few years back, after our supplier for a particular antibiotic raised their price fourfold (they were the only supplier in the world for this antibiotic). A couple of engineers and I were charged with developing our own manufacturing process for this antibiotic. It turned out we had made it back in 1970 and we still had (frozen) a culture that made it. All we needed was an isolation and purification process. We had what we had done in 1970 and we had the patent literature. We found some pretty good processes in the patent literature, copied elements of them and developed a process that would cost us a third of what our supplier was charging. The supplier knew what we were doing and before we had even finished they had cut their price by two-thirds. We never implemented the new process because we got the lower price without having to do so. But until we had made a credible threat of going into business ourselves we could not get the low price. Copying other's (expired) patents made this possible. Had this knowledge existed as trade secrets, it would have been lost as none of the companies that had issued the patents were in the business anymore.

Our unit doesn't do patents, because that requires disclosure in an easily searchable format. We keep everything as trade secrets and disclose them to the public by making a poster presentation at an obscure meeting somewhere. We photograph the poster and the program listing the program as proof of disclosure. Now a competitor cannot independently develop our trade secret and patent it to prevent us from using it because you cannot patent publicly disclosed knowledge.

Growth in the standard of living. If the economy gets a certain amount larger each year, so must your fortune, otherwise your share of the overall pie diminishes.

Exactly and that rise is described by the rise in per capital GDP AND by the rise in R, and by the rise of the real value of the stock index. The price of your stocks grow with the rising living standards. But you also get dividends, which represent excess return over and above the rise in the standard of living. As long as you reinvest some of the dividends your fortune will grow compared to the average fortune.

You're arguing that capital markets in and of themselves cause concentrations of wealth.

Of course they do. How can they not? Think carefully about it. The point of investing in enterprise is to make a better return than passive lending at the risk-free rate of return*. Since industrial times these rates have reflected the ability of nations to tax the rising future wealth of their nations to service the loans secured today. For government finance to be stable, real interest rates must not exceed long-term growth in national income because it is future income that is tapped to service the debt.

Increased national income arises from both increased individual wealth (i.e. growth in R, asset prices, and GDP per capital) and population. As I have shown, individual wealth grows at about 2% rate since 1860. Population since WW II has grown at a about a 1% rate, which means the taxable national wealth has grown at about 3% rate. (Another way to say this is GDP growth has averaged about 3%)

Since 1945 II real T-bills have averaged 0.6%. Moody's Aaa corporates have shown average real rates of 2.7%. Ten year treasuries don't go back to 1945. Since 1953 they have generated about 2.5% in real return. These are all below the 3% level as they need to be over the very long run.

In theory, stock returns, assuming no change in valuation (P/R) over the long term will return 2% (due to long-term accumulation of R) plus average dividends. Since 1945 dividends have averaged 3.6%, giving a total theoretical return of 5.6%. Actual return has been 5.8%.

That is, stocks have returned about 3.3% more than investment in government debt, providing an additional return for enterprise as opposed to just passive lending at the benchmark rate This is the way it has to be, otherwise why start a business or invest in one if you could make just as much money lending out your savings? It has nothing to do with how the economy is structured. If capital markets exist, then this excess return over and above that obtained from passive lending must exist, or the capital markets themselves would not exist.

And that excess return is what creates concentrations of wealth.

Wait, doesn't this assume that all of D is consumed? Isn't it likely that much of D becomes investment in new enterprises which would also contribute to the full value of R?

Very little is invested in this way. The fraction of S&P500 shares traded on the exchanges that represent new issues is vanishingly small. The index I am using the the S&P500 and its precursor the Cowles index, which until the middle of the last century comprised all or just about all of the stocks on the NYSE and since then the largest 500 stocks traded on any US exchange.

That is not to say that D is not reinvested back into R. Much of it is, but mostly by buying shares from other investors on the stock exchange. What these dividend investors are doing is buying more R to add to the R they already own.

One of your charts shows that dividend returns for major stocks are now less than capital accumulation. This provides the data I lacked in my previous post and shows that major corporations have increasingly moved toward re-investment and thus capital growth has centralized in particular firms.

No they haven't. Corporations continue to reinvest the same fraction of R (2%) as they always have. The fundamental return from capital (E) has fallen and so that means there is less D (as a fraction of R) available to pay out to investors. However, the return investors get is not E/R; it is E/P. Their return depends on what they paid for their R. Price determines return, not the company's prospects. Warren Buffet figured this out 60 years ago and that is part of the reason why he has been so successful.

Back before 1920, when E/R was high at about 7%, P/R averaged around 1.0 and stock returns were about 7% in real terms. Since then E/R has run about 5% and P/R has run lower to--an average of 0.64 since 1920 So, though D/R has fallen from 5% to 3%, (i.e. the investment fundamentals have declined since 1920) D/P has only declined from 5% to 4.7%, a pretty small drop for such a big drop in the fundamentals.

The actual growth of the economy is closer to E.

No it's not. E/R runs at about 5%. Economic growth per person tracks R; it grows at 2%.

In order to be part of the idle rich, and maintain one's fortune you need to achieve E plus money to live on. R simply measures the portion of the economy that is aggregating in the firms in whichever stock index you're using.

Wrong. The standard of living rises with GDP per capita. Increases in GDP due to population growth are not reflected in living standards. GDP per capita tracks R not E. The value of the stock index (and hence the value of the idle rich's investments) rises in line with living standards. The dividend return is the extra they can live on, or re-invest if in excess. And reinvested dividends produce additional wealth concentration.

Average real stock returns are about 5% for the post-war period and average real interest rates look to be about the same.

No they are not--see above.

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*Historically, banking developed to make loans to governments, not to businesses. That is not to say they didn't make loans to private parties; they did, but the big business was finance of wars. And so there was a benchmark governmental interest rate (e.g. Venetian Prestiti, Genoese luoghi, British Consols, US Treasuries). The government loans from the biggest most stable nations with the longest record of successful payment formed these benchmark rates which economist term the risk-free rate of interest.

Originally Posted by Kurt Horner

Yes, but going back to the original comment, which is that many versions of socialism still see increasing the stock of capital as the primary goal. Really, all of them do, since socialists desire prosperity and more capital equals more productivity and better goods. The crucial factor is not which one of the silly classical factors of production* is favored by an ideology but questions of ownership and control.

Correct. But before you can have an increasing stock of capital, you have to have capital that exists in a form that can accumulate. If the accumulation is through a market mechanism then you have capitalism, and with that you will get concentrations of individual wealth. In such economies the market-mediated allocation of capital is central to the process of economic growth and development, which is why the term capitalism is used.

If you have markets for goods and services, but not for capital and money, then you have a non capitalistic or traditional market economy. Such economies do not experience economic growth (capital accumulation) in the modern sense of the word. Capital plays an unimportant role. Here labor is typically "attached" to resources, noble estates have their slaves/serfs, other land has their settled pesantry. Wealth is then land/resources, and concentrations of wealth typically arise through military means, by either militarized classes (Feudal nobility) or by governments (monarchs, emperors, etc). Control and allocation of Resources are central.

If you have capital, but it is owned by the state, you have a command economy or what Communist economies were in practice. Here capital still plays a central role, and concentrations occur, but the means through which is is controlled is through politics, not market economics.

If you have capital, but it is collectively owned by the people/workers, you have socialism. In such an economy, problems arise when some people work and others do not. You can handle this by identifying those who everyone agrees can not or should not work (children, the aged and the disabled) and providing for them out of the profits generated by the collectively owned capital.

What about able bodied people who aren't working, that is, the unemployed? You cannot have a situation is which there are large numbers of unemployed, receiving according to their needs while those still employed are producing according to their ability. People will get upset and your workers paradise will collapse. So there has to be an emphasis on allocating capital in order to provide useful jobs for everyone who can (and should) work. That is, optimizing the socially useful employment of Labor, as opposed to the most profitable employment of Capital, is key in socialism.

You can look at it in terms of ownership and control or in terms of which factors of production receive the most attention, and probably in other ways too.

Originally Posted by Mikebert

Generally you have your engineers sign nondisclosure agreements as a condition of employment (I did).

Which is difficult to enforce once they're no longer your employee (or at least should be hard, otherwise an NDA is basically a "voluntary" slave contract).

Originally Posted by Mikebert

Patents promote the spread of technology. Patents provide short term protection in exchange for disclosure.

That "short term" is 20 years. The technology may have spread but it can't be used.

Originally Posted by Mikebert

For example, a few years back . . . Copying other's (expired) patents made this possible. Had this knowledge existed as trade secrets, it would have been lost as none of the companies that had issued the patents were in the business anymore.

You're assuming that a lack of patents means 1) there are no records of technological advances, 2) that the people who develop a product would never release their knowledge, even 35+ years since its invention and that 3) none of the people responsible for the original advance are available and alive. Yes, just looking up the patent was easy. But your assumption that such things would automatically be hard in the absence of a patent system is unsubstantiated.

Originally Posted by Mikebert

Of course they do. How can they not? Think carefully about it. The point of investing in enterprise is to make a better return than passive lending at the risk-free rate of return*.

You need to read this again:

Originally Posted by Kurt Horner

Only if a) all enterprise is funded by debt and b) the life of the average capital good is identical to the term of the loans used to purchase them. In practice, however, capital goods last longer than the loan used to create them, thus the owner of the capital good continues to generate returns after the loan is paid off.

The reason to lend is to get the ROI from someone else's effort. They gain the benefit of using your savings and gaining the ROI once the loan is paid. There is no necessity for ROI to be higher than loan interest in order to have lending occur. There is only the necessity for capital lifespan to exceed loan terms.

Originally Posted by Mikebert

That is, stocks have returned about 3.3% more than investment in government debt, providing an additional return for enterprise as opposed to just passive lending at the benchmark rate. This is the way it has to be, otherwise why start a business or invest in one if you could make just as much money lending out your savings? It has nothing to do with how the economy is structured. If capital markets exist, then this excess return over and above that obtained from passive lending must exist, or the capital markets themselves would not exist.

See above. Capital generates return over a longer period than the loan.

Originally Posted by Mikebert

Very little is invested in this way. The fraction of S&P500 shares traded on the exchanges that represent new issues is vanishingly small.

What about all the other firms in the economy except those making up the S&P500, many of which are so tiny as to not even be publicly held?

Regarding stock returns versus loan interest, I may be missing the part where you quantify this, but my quick look at the prime rate vs. the CPI via the Fed's website shows about a 5% difference. So, it does seem like investment returns are in harmony with loan interest.

Originally Posted by Kurt Horner

Which is difficult to enforce once they're no longer your employee (or at least should be hard, otherwise an NDA is basically a "voluntary" slave contract).

If you sign a contract and then disregard it, what does that say about your honesty? It's not done. We had an employee who used to work for a competitor for the same product we made. He was never asked about what they did, and he did not say.

That "short term" is 20 years.

I think it's 17 years.

You're assuming that a lack of patents means 1) there are no records of technological advances, 2) that the people who develop a product would never release their knowledge, even 35+ years since its invention and that 3) none of the people responsible for the original advance are available and alive.

Sure there are records, internal reports, databooks and laboratory notebooks. All the property of the employer.

Yes, just looking up the patent was easy. But your assumption that such things would automatically be hard in the absence of a patent system is unsubstantiated.

Of course it would be hard. For example, suppose a sales guy asked you to do a quick check on what it would cost to make vitamin K. If you couldn't check the patent literature how would you do it? Most useful knowledge isn't published in journals. You could look up the current manufacturers and probably find most of them are in China. How would you find a disgruntled ex employee willing to talk and do this is a few hours?

There is no necessity for ROI to be higher than loan interest in order to have lending occur.

Nobody is going to borrow money to fund a project whose ROI is less than the rate of interest. You'd be laughed out of the room if you proposed this to management.

There is only the necessity for capital lifespan to exceed loan terms.

Where do you get this idea? Who thinks this way?

What about all the other firms in the economy except those making up the S&P500, many of which are so tiny as to not even be publicly held?

What about them?

I came up with a quantity I call business resources or R. I give a simple formula to explicitly calculate it. You can use R to value the S&P500 index, which is usually considered by investment professionals to be a good barometer of the entire stock market. I then showed that R works better to value the index than the two other leading competitors, P/E and Tobin's Q.

It makes sense that the company should be worth the total amount of retrained profits accumulated since it began. This is what a book value or shareholder equity is about.

I also show that R tracks GDP per capital. If you write the process of GDP creation as a reaction you get something like this:

Resources + Labor --> Output

Capital serves as a catalyst. it affects the rate of the reaction, but is not consumed. It does degrade with time (depreciate) just as a real catalyst does. I assume that this "reaction" is first order in Labor and zero order in Resources. The reasoning is as follows:

If one person can make 5 widgets per hour, two people should be able to make 10 per hour, at least on average. Doubling the number of workers doubles the rate of production. That is, output rate is proportional to number of people.

Suppose the widget making machine consumes 5 gallons of oil per hour and you have 50 gallons of oil in the fuel tank. If you double the amount of oil in the tank to 100 gallons, you double the number of widgets that can be produced before the oil runs out, but you do not affect the rate of widget production.

Output is proportional to number of people (first order), but independent of amount of resources (zero order).

This means we can write a rate expression for economic output generation as follows:

Rate of Output (GDP) = K' * number of people = K' * P

Here P is population. Solving for the rate constant K' yields

K' = GDP / P = GDP per capita

Now the rate constant is affected by the amount of catalyst (capital) present. Double the amount of capital (C) and you double the rate. Thus we can write

GDP per capita = K' = k * C

Now I have already shown that GDP per capita is proportional to R. This means that C is proportional to R. That is, R can be used as a proxy for the capital stock in the economy.

The definition of R involves an accumulation of profits, which is the same mechanism that causes the accumulation of capital responsible for economic growth. This means that we should be able to gain insight into how capital accumulates (which is not easily measured directly) by studying how R accumulates, which can be easily calculated. That R has some real world validity was shown by its ability to value the stock market, which should be a market reflection of capital accumulation in the broader economy.

R is part of a model for economic growth. As with most models, it is an abstraction that has some explanatory power. For example, using R I can show that your claim that companies are sequestering more profits today than in the past is probably not correct.

Regarding stock returns versus loan interest, I may be missing the part where you quantify this, but my quick look at the prime rate vs. the CPI via the Fed's website shows about a 5% difference.

Typically the prime rate is about 300 basis points above the Fed Funds rate, which is very close to the t-bill rate. That would give a 3.6% average over the postwar period. Did you average the data over the entire period or just look at a subset of the data? There were times when the 10-year rate was 5-6% above inflation and times when it it was below the rate of inflation.

Also, the prime rate is a fixed, non-market rate, like credit card rates or personal loans between individuals. Neither reflects the market-set cost of money. All are higher than market rates. Lenders will pay more than the market rate for convenience (prime rate, credit cards) or because they cannot qualify for normal loans (personal loans). Investors do not get the prime rate.

If you want to invest in debt you buy bonds or bills. And for those, the rates I cited are the relevant rates, not the prime rate. The data is all available at www.economagic.com.

Originally Posted by Mikebert

If you sign a contract and then disregard it, what does that say about your honesty?

Employment is a trade. When that trade is no longer occurring, it is completely unreasonable for one party to continue to extract new benefits. You're arguing that a worker does not have ownership over his own technical knowledge.

Originally Posted by Mikebert

It's not done.

Also, soldiers tend to obey their officers. The compliance of many workers with such demands is not proof that such arrangements are reasonable, or even that those workers truly consent to such practices.

Originally Posted by Mikebert

I think it's 17 years.

It was. Now it's 20. Not that it matters, since 17 years is absurd too.

Originally Posted by Mikebert

Sure there are records, internal reports, databooks and laboratory notebooks. All the property of the employer.

Note the assumption here -- of a world where most technical jobs are wage labor for large organizations that have an advantage in bargaining power. It is also a world where it is possible to "own" knowledge and prevent someone from making use of knowledge they possess. The records you're talking about would not necessarily remain the property of employers and likely wouldn't.

Originally Posted by Mikebert

Nobody is going to borrow money to fund a project whose ROI is less than the rate of interest. You'd be laughed out of the room if you proposed this to management.

This is only true if we're talking in NPV terms. But a piece of capital equipment that generates 5% for ten years is worth paying 5% loan interest for five years. Many companies will even go negative for a period in order to reap greater profits down the road.

Originally Posted by Mikebert

What about them?

You're taking the S&P500 as a representative sample of the entire economy, when they are not even a representative sample of publicly traded companies.

Originally Posted by Mikebert

It makes sense that the company should be worth the total amount of retrained profits accumulated since it began. This is what a book value or shareholder equity is about.

The individual company, yes, but you're trying to gauge the economy as a whole. As long as some of the profits from the S&P500 are used to create capital in other firms you are underestimating the growth of capital by using this measure.

Originally Posted by Mikebert

If one person can make 5 widgets per hour, two people should be able to make 10 per hour, at least on average. Doubling the number of workers doubles the rate of production. That is, output rate is proportional to number of people.

You're assuming that the efficiency of capital goods employed in the S&P500 is representative of the economy as a whole. Frankly, I find that highly unlikely. My personal experience (and I think that of most people) is that larger companies are considerably less efficient and are often legendary in their capacity for stupidity and persistent waste.

Originally Posted by Mikebert

Typically the prime rate is about 300 basis points above the Fed Funds rate, which is very close to the t-bill rate. That would give a 3.6% average over the postwar period. Did you average the data over the entire period or just look at a subset of the data? There were times when the 10-year rate was 5-6% above inflation and times when it it was below the rate of inflation.

You are correct that I slightly overestimated this difference (using the prime rate), however my point was to show that loan interest for capital purchases (which averages a bit higher than the prime rate) is comparable to investment returns. Yet, somehow, the economy continues to grow.

Originally Posted by Kurt Horner

You're taking the S&P500 as a representative sample of the entire economy, when they are not even a representative sample of publicly traded companies.

The individual company, yes, but you're trying to gauge the economy as a whole. As long as some of the profits from the S&P500 are used to create capital in other firms you are underestimating the growth of capital by using this measure.

Of course the S&P500 is not the same as the economy (there exists economic activity in the SU economy that is outside of the S&P500). The question is whether it behaves sufficiently similar to the economy as a whole to function as a useful model. To answer the question I construct R and test it by compared it to GDP per person. If the S&P500 were not a good model, then R woudl grow at a different rate than GDP per capita. It doesn't, so that means its a good model.

I am not justifying the use of R based on theory. I am justifying it based on the fact that it works. It does describe the rise of the market over the long run. It does match the trend in GDP per capita over the long run

You're assuming that the efficiency of capital goods employed in the S&P500 is representative of the economy as a whole.

Yes I am (see above).

Frankly, I find that highly unlikely. My personal experience (and I think that of most people) is that larger companies are considerably less efficient and are often legendary in their capacity for stupidity and persistent waste.

In actual fact, large companies have greater intrinsic efficiency due to larger resource base (they have employee experts covering all details of a complex business process whereas employees of small companies have to wear many hats) and economies of scale. These advantages are countered by the greater difficulty of decision making in a bureaucracy. Overall the efficiency will be about the same because the two kinds of business are constantly interacting, growing and shrinking relative to each other as their efficiencies change.

And I know this because if it were as you imply, R would grow more slowly than per capita GDP. It doesn't and so your intuition is not correct.

You are correct that I slightly overestimated this difference (using the prime rate)

5 versus 3.6 is a 30% difference, hardly slight.

my point was to show that loan interest for capital purchases (which averages a bit higher than the prime rate) is comparable to investment returns.

You have been making a claim that investment loan interest is about the same as ROI. What is the evidence?

First you gave as evidence a 5% real prime rate, when in actually it is considerably less than 5%. And you didn't show that the prime rate was relevant for investment.

Now you assert that investment loans are at rates higher than the prime rate. You ignore the corporate bond market with its lower interest rates. If you have an investment worthy of pursuing and retained profits are not enough, why not issue corporate bonds at bond rates, rather than borrow at twice the rate, as you claim is done.

Actually the average cost of money for investment will be the weighted sum of the effective rates on (1) retained profits (2) bond issues and (3) loans from banks and bank-like entities.

Only (3) will carry a prime-type rate. (2) will carry a bond rate and (1) will carry the rate of the alternative (liquid) investment, which would be a mix of shorter-term government securties and commercial paper, and probably yield 1-2% in real terms over the long run. The average of these three would be closer to the bond rate than either of the others, and that is why the bond rate is usually used as a proxy for the cost of money for investment.

Where did you get this notion that businesses pay a cost of money for their investments that is about the same as the ROI from such investment. Can you provide a url? Or is it your own idea?

Originally Posted by Mikebert

If the S&P500 were not a good model, then R would grow at a different rate than GDP per capita. It doesn't, so that means its a good model.

I don't think that's an adequate proof of the model. You are correct that GDP per capita does not falsify your model.

Originally Posted by Mikebert

In actual fact, large companies have greater intrinsic efficiency due to larger resource base (they have employee experts covering all details of a complex business process whereas employees of small companies have to wear many hats) and economies of scale. These advantages are countered by the greater difficulty of decision making in a bureaucracy. Overall the efficiency will be about the same because the two kinds of business are constantly interacting, growing and shrinking relative to each other as their efficiencies change.

You're assuming the playing field is level and that the distribution of firm size that we see is a result of markets -- which is to say that you are, yet again, assuming your conclusion.

Originally Posted by Mikebert

And I know this because if it were as you imply, R would grow more slowly than per capita GDP. It doesn't and so your intuition is not correct.

Not so. If the larger firms are, as I contend, net beneficiaries of state intervention, then their performance will remain strong despite inherent inefficiencies. The contention that capital efficiencies are identical regardless of firm size is not proven by this at all.

Originally Posted by Mikebert

5 versus 3.6 is a 30% difference, hardly slight.

Yes, but the prime rate is the floor for loan interest, and many loans are at higher rates. So, the loan interest rate for capital purchases is likely close to ROI.

Originally Posted by Mikebert

Now you assert that investment loans are at rates higher than the prime rate.

Which, they are. The prime rate is rate for the most creditworthy borrowers. Many borrowers get higher rates.

Originally Posted by Mikebert

You ignore the corporate bond market with its lower interest rates.

For A-rated and higher maybe, but what about everything else? The corporate bond market as a whole does not have lower yields. See for example this article disputing the so-called "equity premium."

Originally Posted by Mikebert

If you have an investment worthy of pursuing and retained profits are not enough, why not issue corporate bonds at bond rates, rather than borrow at twice the rate, as you claim is done.

Perhaps because many firms cannot issue bonds cheaper than they can go into debt. Very large, well established firms will tend more toward bond financing.

Originally Posted by Mikebert

Where did you get this notion that businesses pay a cost of money for their investments that is about the same as the ROI from such investment. Can you provide a url? Or is it your own idea?

See above, but if you think about it -- it's anomalous for it to be any other way. The long run trend in any market economy should be for interest rates to converge toward a single uniform value. This is because anything yielding a greater return will draw more competition, thereby driving down returns and vice versa. Granted, the market is constantly being perturbed by new conditions and there is always at least some preference for short term over long term but the tendency of the market should be toward a single rate.

Now, it's entirely possible that, in the economy we actually have, funds are raised over similar time frames as capital depreciation. If that were true, then, yes, there would have to be an equity premium for the economy to grow. However, there's no requirement that an economy be structured that way.

Consider a consumer good example. Would you buy a car on a three year loan if the average car stopped running after just three years? Yet, you seem to be proposing that businesses should purchase tools that will break down the moment they're paid off.

Originally Posted by Kurt Horner

I don't think that's an adequate proof of the model. You are correct that GDP per capita does not falsify your model.

You cannot ever prove a model, all you can do is falsify it. The fact that it was not falsified is a point in its favor.

Yes, but the prime rate is the floor for loan interest, and many loans are at higher rates. So, the loan interest rate for capital purchases is likely close to ROI.

Here you have done a bait and switch, although I don't think it is intentional. The issue is whether or not the cost of the money (interest) used for investment is about the same as (your claim) or less than (my claim) return on investment. The cost of money for investment is NOT the same thing as the rate of interest on loans. This would be exactly true if the only source of investment funds were loans. It would be largely true if the vast majority of the money used for investments came from loans. But you have not shown that this is the case.

I looked up some data at economagic.com. I find that the average net private fixed nonresidential investment over 2000-2007 was $260 billion annually. That's a mouthful but the explanation is simple. I am interested in business investments and so that is going to be private and nonresidential. I am interested in the investment that builds capital, that is total investment less capital consumption (depreciation) = net investment. And I do not want to include investment in inventories as that is not really the sort of capital that we are considering here, so I want fixed.

In the same database I find the average undistributed (retained) corporate profits over the same period was 212 billion. This is not the total retained profits in the economy because it does not count profits from firms that are not public corporations, so this 212 billion figure represents a lower bound on the profits available to fund the $260 billion in investment. As such you can see that retained profits are large enough to provide most of the money needed to invest in new capital formation. There is no reason to believe that most of the money for new investment comes from loans.

Now the cost of money for retained profits is the return to holding cash, that is, short term government securities, corporate paper and bank savings accounts.

If you do not have cash, you can borrow somebody else's cash by making a loan from a bank or a bank-like entity or obtain capital by selling bonds or stock. Obviously this happens. Small businesses who wish to expand faster than their retained profits will let them have to borrow, because they are too small to float a bond issue. And I expect you had this in mind. But quantitatively a small fraction of all investment makes use of loans as opposed to retained profits.

Now the paper you cite shows that return form capital is equal to interest income less a small premium due to nondiversifiable risk. You have conflated their interest return with business's cost of capital.

The paper is talking about interest returns to households. They do not say from where these returns come. Yes, some of that interest return comes from business, but the vast majority comes from government and household borrowing. Unlike households and government, businesses earn profits which can be invested. Consider the huge government debt and the huger mortgage debt, both of which dwarf aggregate corporate bonds. These non-business debts provide interest return to households, but do not represent costs to business.

Mike/Kurt - good stuff (some good stuff from Brian and Indy as well earlier); seems to almost verge into name-calling but stops just short. Much appreciated.

Any chance of a short, perhaps 'bulleted,' summary from either one or both of you of the main points/differences to date on this chain? Just to check if I'm following correctly; its complicated and there is a lot of asides and detail one can get lost in. I'm sure some other bystanders would very much appreciate it as well.

Originally Posted by Mikebert

Here you have done a bait and switch, although I don't think it is intentional. The issue is whether or not the cost of the money (interest) used for investment is about the same as (your claim) or less than (my claim) return on investment. The cost of money for investment is NOT the same thing as the rate of interest on loans. This would be exactly true if the only source of investment funds were loans. It would be largely true if the vast majority of the money used for investments came from loans. But you have not shown that this is the case.

I understand that loans are not the only means for raising funds to purchase capital. I noted that a) loan interest is not consistently lower than ROI and that b) neither are corporate bond rates. It is fair to say, though, that I have not properly addressed whether c) retained profits cost a comparable amount. But I am not making the error that loans are the only way to buy capital goods.

Originally Posted by Mikebert

Now the cost of money for retained profits is the return to holding cash, that is, short term government securities, corporate paper and bank savings accounts.

Only if they were holding cash forever. But, they don't -- they hold it until an investment opportunity arises and then they have the funds available at zero interest. However, they have "paid" interest, in the sense of leaving that money to sit before employing it productively. Which means that this situation is price-wise identical to the loan scenario. The returns go away for X years and then accrue to the firm for Y years after that.

Now, granted, most firms do hold cash in interest bearing form at very low rates. Generally, these keep pace with inflation. However, we're talking about returns over inflation, which are determined by the duration the cash is held.

Originally Posted by Mikebert

Now the paper you cite shows that return from capital is equal to interest income less a small premium due to nondiversifiable risk. You have conflated their interest return with business's cost of capital.

The paper is talking about interest returns to households. They do not say from where these returns come. Yes, some of that interest return comes from business, but the vast majority comes from government and household borrowing. Unlike households and government, businesses earn profits which can be invested. Consider the huge government debt and the huger mortgage debt, both of which dwarf aggregate corporate bonds. These non-business debts provide interest return to households, but do not represent costs to business.

I'm not clear how any of these things matter to the point under consideration. The paper was discussing returns from equity versus returns from debt and pointing out that the differences are not significant. Does it really matter whether you're looking at things from the creditor side (households making investments) or the debtor side (firms desiring the funds)? The transaction is the same regardless.

Originally Posted by playwrite

Mike/Kurt - good stuff (some good stuff from Brian and Indy as well earlier); seems to almost verge into name-calling but stops just short. Much appreciated.

Any chance of a short, perhaps 'bulleted,' summary from either one or both of you of the main points/differences to date on this chain? Just to check if I'm following correctly; its complicated and there is a lot of asides and detail one can get lost in. I'm sure some other bystanders would very much appreciate it as well.

I think I can do this.

Mike argues that there is a consistent difference in the rate of return on capital relative to return on debt, inherent in the existence of capital markets, that causes aggregation of wealth. From this, he argues that a capital market will always create inequalities of wealth that must be corrected by other policies (progressive taxation, etc).

I argue that the apparent differences in return don't exist and that its fairly illogical for such a difference to persist. Thus, wealth inequalities must result from other structural factors (patents, transportation subsidies, corporate personhood and many, many, more).

A simplified version:

Mike: Equities beat debt in the long run.

Kurt: It doesn't make sense that they would, since higher returns should lure funds, thereby eliminating the difference.

Mike: Yet, the differences occur.

Kurt: These differences get a lot smaller upon closer examination.

And now we're into the details of those arguments . . .

Hopefully, I haven't misrepresented Mike's views in the summary above.

Originally Posted by Kurt Horner

Mike argues that there is a consistent difference in the rate of return on capital relative to return on debt, inherent in the existence of capital markets, that causes aggregation of wealth. From this, he argues that a capital market will always create inequalities of wealth that must be corrected by other policies (progressive taxation, etc).

Not exactly. I do believe that there exists a difference in the rate of return on capital relative to return on debt. Kurt does not.

I do not say that this difference is what is responsible for aggregation of wealth. This whole argument about the the return from debt versus equity is a side issue. Kurt apparently thought it was relevant to the central argument and brought up the "fact" that the cost of money to capitalists is the same as the return to capital as evidence against my position[/i]. I questioned whether his assertion was indeed fact and away we went (see bottom for latest salvo in this argument)

I argue that the process of capital accumulation itself causes aggregation of wealth. As long as capital markets exist (which is a precondition of capitalism) then wealth can be exchanged for capital (and vice versa). Since a capitalist economy features capital accumulation (this is the definition) and capital can be exchanged for wealth, wealth accumulates.

Now concentrations of wealth will occur unless everyone starts with equal amounts of capital and sees the same average rate of return. Are these good assumptions? The answer is no. The reason is even if all participants are equal in every way, the results they see will differ due to random walk effects. The outcome of successive investments (steps) will differ, creating winners and losers spontaneously, without any institutional "thumb on the scale".

Here's a simple illustration. Thirty families each have 100 units of capital (wealth). Every step sees a return on capital between -25 and +60 units. This is a random walk that is centered on a +5 gains in capital per step. Implmenting this in Excel (the formula I used for return was 60*X-25 where X is an random number between 0 and 1) I get the following values after 100 steps:

859, 940, 546, 514, 832, 524, 841, 800, 311, 617, 671, 732, 773, 715, 772, 623, 775
636, 601, 411, 518, 633, 577, 646, 520, 0, 520, 736, 480, 750

If at any time capital went negative I recorded a zero for that family's capital.

The average family is worth 629 units. That is, they gained an average of 5.29 units per year, which is not surprising since the formula was designed to give an average gain of 5 units. The richest 3% of families has more wealth than the bottom 10%.

Hence we can already see winners and loser as a result of a purely random walk. When you consider that real world performance is not random, (there is such a thing as talent and industry) discrepancies between outcomes grow much faster than in this simple model.

During colonial times (particularly in Puritan and Quaker areas) a "natural experiment" along these lines happened. Families began with equal allotments of land when the colony was established. After a generation or two, huge variations in familial land holdings were observed. A handful of lucky (or skilled) families did well in the early years, while others did poorly and were forced to sell their land to meet debts (i.e. they suffered the fate of my "zero" family).

Those who happened (for whatever reason) to have done well early on were able to buy land on the cheap with their excess profits, increasing their land holdings. Buying good assets cheap is a safe way to get outsize profits (ask Warren Buffet). With more land holdings, the richer families were more diversified, which protected them from rare, disastrous losses (i.e. they never could go to zero from purely random walk effects). The ability of rich families to buy cheap land when available still provided an upside to return. Thus, rich families now enjoyed asymmetric returns, not because they had institutional power, but because they were rich (because of their unusually good (lucky) results early on) and so have money during hard times with which to buy low-priced capital. Low-priced capital is heavily biased towards above average returns.

This is how many of the great fortunes were made. Andrew Carneige was a steel man who did well (was lucky?) initially and so happened to have money to buy the assets of bankrupt steel mills during depressions. He was able to buy them because steel mills have no immediate value in a depression when steel making is profitless. But if you have deep pockets you can take losses during the depression, and when the recovery occurs you now have the capital to reap enormous profits, building a war chest for the next depression, when you do it all over again. Somebody has to do well initially, by random luck if nothing else (see above), so there will always be a Carneige.
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Most of the recent discussion has focused on the side issue of the cost of money (what business pays for the money they invest) compared to to the return from the capital in which they invested. Kurt argues that there is no difference between the two:

I argue that the apparent differences in return don't exist and that its fairly illogical for such a difference to persist.

The differences do exist, but I do not think Kurt understands what I was talking about. In the article Kurt cites, the authors found that the return from interest to households was only about 1% lower than the return on equity (that is, pretty close, although still different and in the way I argue).

In their study they adjusted returns for the effect of taxation. For example, interest is taxed at a lower rate because much of the interest was in tax-protected insurance and pension funds, while most dividends are fully taxed. Thus, although real return from debt is actually considerably less than real return from equity on a pre-tax basis, when taxes are considered the difference shrinks (recall top tax rate on both was over 70% for more than 50 years during the period considered so taxes can matter).

But to the business borrower, what tax rate the lender pays is of no direct concern, what matters is the expense to them. And the interest business pays has been less than the return on capital. If this were not so then we would see much less borrowing and more use of equity finance by business than we actually see.

Originally Posted by Mikebert

I do not say that this difference is what is responsible for aggregation of wealth.

You didn't make that clear, which explains the debate since.

Originally Posted by Mikebert

I argue that the process of capital accumulation itself causes aggregation of wealth . . . The reason is even if all participants are equal in every way, the results they see will differ due to random walk effects.

Yes, but future returns are also subject to the random walk in proportion to the amount of capital owned. The fallacy of everything that followed in your analysis is to treat each person as a single unit for purposes of random returns, when the proper unit of analysis would be each piece of capital.

Originally Posted by Mikebert

Hence we can already see winners and loser as a result of a purely random walk. When you consider that real world performance is not random, (there is such a thing as talent and industry) discrepancies between outcomes grow much faster than in this simple model.

Talent and industriousness would also reduce the effects of bad luck. Isn't the point of a random walk to model differences in underlying variables without actually discovering them? You seem to be treating it as a theoretical minimum amount of diversity.

Originally Posted by Mikebert

But if you have deep pockets you can take losses during the depression, and when the recovery occurs you now have the capital to reap enormous profits, building a war chest for the next depression, when you do it all over again.

Leaving aside the begged question of where these depressions came from in the first place, this still makes little sense. Somehow the gains in the boom are skewed, but the losses are relatively uniform, thus allowing the big gainers in the boom to come out ahead during the bust. We should be seeing losses randomly distributed amongst all capital owned which means that people with more capital should have proportionately higher losses.

****
On difference in returns . . .

Originally Posted by Mikebert

But to the business borrower, what tax rate the lender pays is of no direct concern, what matters is the expense to them. And the interest business pays has been less than the return on capital. If this were not so then we would see much less borrowing and more use of equity finance by business than we actually see.

a) As was pointed out above, the claim that businesses consistently pay less interest than the return on capital isn't substantiated. Since borrowing typical occurs slightly above the prime rate and returns are typically slightly above the prime rate, you cannot make a decisive claim that there is a difference.

b) Your conclusion about the relative value of borrowing is also unwarranted due to arguments previously stated (e.g. that interest need not be different from ROI for an investment to be sound, only NPV needs to be higher). Rather, the decision between means of growth is an institutional factor. Management prefers growth methods that maximize their control over the process, thus you get internal funds first, debt second and new equity third.

Originally Posted by Kurt Horner

Yes, but future returns are also subject to the random walk in proportion to the amount of capital owned.

Except as your wealth accumulates you necessarily diversify. Instead of one farm/enterprise you now have two and then three and so on. Once you have several properties a calamity that affects only one doesn't wipe you out as it would have had it hit when that one property was all you had. Your upside diminishes as well, except for the opportunity your wealth brings you to buy distressed assets.

The fallacy of everything that followed in your analysis is to treat each person as a single unit for purposes of random returns, when the proper unit of analysis would be each piece of capital.

In the simple model each family was assumed to have a single piece of capital, their farm or business.

Talent and industriousness would also reduce the effects of bad luck.

Yeah, and enhance returns too. How does this matter?

Isn't the point of a random walk to model differences in underlying variables without actually discovering them?

Huh? A random walk is a model for processes resulting from random action, like diffusion, and dispersion of chromatographic peaks.

You seem to be treating it as a theoretical minimum amount of diversity.

It is.

Leaving aside the begged question of where these depressions came from in the first place,

Which is irrelevant.

We should be seeing losses randomly distributed amongst all capital owned which means that people with more capital should have proportionately higher losses.

You do. People with large amounts of wealth can afford to not have all of it invested and still out earn those with less.

Suppose I have 300 units of capital and you have 100 units and the return during boom times is 10%. You have 90 units invested and 10 in savings You receive 9 units of income, six of which you live on and thee of which you reinvest to grow your capital by 3%.

I have 200 units of capital at work and 100 units in cash. I earn 20 units, live on eight and reinvest the rest to grow my capital by 12 (4%). I grow my capital faster than you do and I enjoy a higher standard of living than you.

Now lets say a recession hits and earnings are -5%. You lose 4.6 units, which comes out of your savings. You cut back slightly and live on the other 5.4.

I lose 10 and with my living expenses, take a hit of 18 on my savings, reducing it to 82.

A neighbor of yours, who also has 100 units, was not as wise as you. He had all of his capital invested and when recession hit has no savings. He owes creditors you are threaten to drive him into liquidation. He offers to sell you his business at 50 cents on the dollar.

It's a tempting offer, but you have no money and borrowing 50 units is risky in this environment so you turn him down. He then makes his offer to me, which I accept. I now have 344 units of capital, 312 of which is invested. You have 93.

If the recession continues another year (most unusual) I will lose another 15 units and consume another 8 in living expenses and will deplete my savings to just 9. It doesn't, and the next year sees me with 31 units of income, 8 of which a live on and the rest I put into savings, increasing my savings to 56. A second year of boom gets my savings back to 78. A third year to 102. After three years you have built your savings back to 10.

You are at 103 units, 93 invested and 10 in savings, up 3 over the business cycle. I have total assets of 414, 312 invested and 102 in cash, up 114 in the cycle.

The difference in our results is because I was rich (meaning I had surplus income over and above what I needed to live on) I could reinvest as much as you and put much more money into savings. These savings allowed me to buy assets on the cheap. It's not like my (invested) capital behaved differently, it took the same losses and gained the same gains as yours did.

I made better gains that you simply because I happened to start out with more. The 3:1 advantage is just the sort of thing that could arise from an initial even position by random luck. Once you have the extra wealth, if you are prudent, you can build up a fortune.
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Your conclusion about the relative value of borrowing is also unwarranted due to arguments previously stated (e.g. that interest need not be different from ROI for an investment to be sound, only NPV needs to be higher).

Whether it needs to be different is irrelevant. The question is one of fact. Is the cost of money for capital accumulation equal to the return or capital or not? I address this issue in my next post.

Thanks, guy. Fascinating stuff, and much appreciated. I was a little off on my interpretations so this helped.

Backing up a little. I'm pretty sure Kurt is opposed to some level of wealth accumulation, but only if due to "other structural factors (patents, transportation subsidies, corporate personhood and many, many, more)." This would derive from a Libertarian bent (thus pertinent to this thread) for those "other structural factors" are likely due to direct or indirect govt involvement. If the opposed level of wealth accumulation was just the normal outcome of the capitalist system, as I believe Mike proposes, then wealth accumulation would not be a Casus Belli for the Libertarian.

Mike may or may not be agnostic when it comes to concern for wealth accumulation. Either way, he is attempting to make the case that if one is concerned about wealth accumulation, one needs first to accept that accumulation is a natural outcome of the capitalist system which would then lead one to conclude that some extraordinary measures (e.g. progressive taxation) has to be applied to counter the natural process of the capitalist system (i.e., again, if one is concerned about wealth accumulation).

Kurt see the cause of the "problem" being the extraordinary (vis-a-vis a pure capitalist system) measures by the govt whereas Mike sees the extraordinary measures of govt (different measures but still originating with the govt) as the solution. The former sees govt activism as the problem (a Libertarian viewpoint), the latter sees govt activism as a solution (a Progressive viewpoint).

So, the key here is the nature of the pure capitalist system without any extraordinary measures -- and therefore, the intense debate. Correct?

Originally Posted by Kurt Horner

I understand that loans are not the only means for raising funds to purchase capital.

Point taken.

I noted that a) loan interest is not consistently lower than ROI and that b) neither are corporate bond rates. It is fair to say, though, that I have not properly addressed whether c) retained profits cost a comparable amount. But I am not making the error that loans are the only way to buy capital goods.

And I note that (a) the prime rate is consistently lower than ROI; only those loans whose interest rate is more than 0.6% above prime are above average ROI. (b) I noted that the bond rate was consistently below ROI; only those bonds issued at rates more than 1.5% above the Aaa rate are above ROI. (c) You did make the error when you compared a falsely-high prime rate to the ROI as a means to support your assertion that interest is equal to ROI.

You have not shown that most of the funds used for investment are at real rates above ROI.

Only if they were holding cash forever. But, they don't -- they hold it until an investment opportunity arises and then they have the funds available at zero interest.

A smart capitalist will have a quite a bit of cash on hand most of the time so yes they generally hold a pool of cash forever. Money is withdraw out of this pool to invest, but retained profits flow into this pool to replenish it. The return from the pool (short term interest) is the cost of money for investments funded from the pool.

However, they have "paid" interest, in the sense of leaving that money to sit before employing it productively.

No they haven't paid anything. They receive interest from the pool. Yes there is the idea of an intangible expense of not getting equity-type return from their cash assets. But this is balanced by the opportunity cost of not holding cash. So it is best to use the return on cash as the cost of retained earnings. This is why businesses retain earnings in the first place, it is the cheapest form of finance. Bonds are next, then loans and finally equity.

If what you say were correct, then businesses would pay out all their profits as dividends and borrow for investments.

I'm not clear how any of these things matter to the point under consideration. The paper was discussing returns from equity versus returns from debt and pointing out that the differences are not significant. Does it really matter whether you're looking at things from the creditor side (households making investments) or the debtor side (firms desiring the funds)? The transaction is the same regardless.

No it isn't. The authors of the article are trying to explain the behavior of households, who are the ones who allocate capital. And so they examine the return to households, not what the business pays. They make adjustments to the rates for the effects of taxes, for example, they note that the effect of taxes was higher on dividends than on interest, and they adjust interest rates upward to reflect this.

Originally Posted by playwrite

So, the key here is the nature of the pure capitalist system without any extraordinary measures -- and therefore, the intense debate. Correct?

Exactly. Capitalism involves the accumulation of capital (wealth). That is what it IS. Unless capital is accumulated at exactly the same rate by all players, concentrations of wealth will occur.

I showed that even if you assume no different behaviors between capital-holders, modest concentrations of wealth will arise through sheer random processes.

But capital holders do have different behaviors. Those who are more thrifty and industrious than average (and lucky of course) will develop larger concentrations of wealth than the random outcome, while those who are more spendthrift and lazy than average (and unlucky) will lose their capital.

Once a concentration of wealth arises, the wealth must be held in more than one pot, and so becomes diversifed. Diversification protects against the effects of luck. If you are sufficiently rich and diversified, random walk type factors become inoperable.

Rich capitalists have an advantage over poor capitalists in that they need to spend a smaller fraction of their return on living expenses. They can save and reinvest more than their poorer peers and so grow faster than they do. And it is simply their larger wealth that lets them do it.

Thus, once a dispersion occurs, which must happen due to random processes, the dispersion will become more extreme because of the capitalist process. By capitalist process I mean retaining rather than spending your returns.

The capitalist process is irrational. If you already spend less than your capital earns, why augment your capital still more? Noncapitalists don't so this. Once their return from capital matches their spending desires they stop accumulating and start spending (i.e. they retire).

Kurt, I dug up my data and will try to explain what I meant about household versus businesss when I talked about the paper you cited.

First I calculated E/P for the 1929-2003 period and got an average return on capital of 4.2%. The NIPA data in the paper covers the same period and it looks like about 4% from Figure 3. I get the same ROI as they do.

They say they used high grade bonds whch means they used the Aaa series like I do. So, I averaged the corporate bond index rates from 1871 to 1920 and got 5.2%. From this I subtracted the average inflation over the same period of 1.2% to get 4.0% real interest rate. Figure 4 in the paper shows a 4% rate. I get the same result as they do.

Now I do exactly the same thing for the 1946-2002 period and get 6.8% average interest less 4.1% average inflation to get 2.7% bond return. They get just under 4%. Now how come they get the same result as I do for the early period, but not for the recent period?

The answer is the values they report are not the raw data, which is what I used and what they used for the early period. That is, their result is not the rate actually paid by the borrowers.

What they show is an adjusted rate, one that takes into consideration different tax policies and such, that is, it shows the effective return actually experienced by the lenders. Since interest is taxed less than dividends the effective interest rate (from the pov of the lender) is higher than its face value. For example, one calculates effective rates on municipal bonds (which are tax free) in order to compare them to taxable bonds. From the point of view of a lender in a 50% tax bracket, a 3% muni bond rate has the same return as a 6% government bond. Yet the rate the municipality pays is 3%, while the government pays 6%.

So this 4% real interest rate they show in Figure 4 is not what the borrows paid. They paid the average real interest rate of 2.7% over the 1946-2003 period just as they paid the average real interest rate of 4.0% over the 1871-1920 period.

2.7% is lower than 4.2% return on equity.

Now they assume that the return on equity in the early period was the same as it was for the latter period. If this were true, then the 4% real interest rate (which I agree with because I get it too) would be the same as the return on equity. But they don't show any data for the return on equity before 1929, when the NIPA data begins.

When I calculate return on equity using E/P I get 7.0% for the 1871-1920 period. For that period, interest paid is still lower than return on equity.

These observations move me to believe that interest paid is less than return on average. This is not a theoretical derivation, it is just what I observed. When the facts don't fit your theory, you aren't supposed to discount the facts.

Originally Posted by Mikebert

Except as your wealth accumulates you necessarily diversify. Instead of one farm/enterprise you now have two and then three and so on. Once you have several properties a calamity that affects only one doesn't wipe you out as it would have had it hit when that one property was all you had. Your upside diminishes as well, except for the opportunity your wealth brings you to buy distressed assets.

Except that, one's ability to manage a large amount of capital diminishes with the quantity. This ties in to a point below . . .

Originally Posted by Mikebert

{Talent and industriousness would} enhance returns too. How does this matter?

You attempted to use differences in ability as a way of exacerbating the proposed differences in outcome (i.e increasing the upside). Since ability will also reduce the downside outcomes, your argument isn't valid. However, there's a more significant reason why this argument should be thrown out . . .

Originally Posted by Mikebert

Huh? A random walk is a model for processes resulting from random action, like diffusion, and dispersion of chromatographic peaks.

Capital investment outcomes aren't random, as you've admitted. Talent plays a role. The only reason one would use a random model for a non-random process is in order to avoid the complicated (and potentially impossible) process of predicting those outcomes.

This is why the "talent" argument you used above is problematic. Differences in talent are precisely one of the things you're already modeling by using a random walk. The other problem is that you're assuming that the ability of persons to manage capital is constant regardless of the quantity of capital owned. This is more than just a simplification, it's just plain inaccurate. All human beings reach a point of being overburdened and become less efficient the more tasks they attempt to undertake in the same period.

Of course, you might object that those with more capital can simply hire people to help manage their capital. However, since this costs money and thereby grants their employees the capacity to save and obtain capital themselves you have now imposed limits on capital accumulation.

Originally Posted by Mikebert

Suppose I have 300 units of capital and you have 100 units and the return during boom times is 10%. You have 90 units invested and 10 in savings You receive 9 units of income, six of which you live on and thee of which you reinvest to grow your capital by 3%.

I have 200 units of capital at work and 100 units in cash. I earn 20 units, live on eight and reinvest the rest to grow my capital by 12 (4%). I grow my capital faster than you do and I enjoy a higher standard of living than you.

This has the same assumption that I note above, that management, maintenance and utilization of capital can be done by one person regardless of the quantity of capital. If, instead, there are limits you get a situation like this:

I have 200 units of capital and you have 100. After a year I have earned 20 units and you have earned 10. Both of us spend 5 units on consumption but I have to hire an employee. He also consumes 5 units. The result is a system where there are three persons gaining income from 105 units of capital each and capital ownership does not lead to inequalities of wealth.

It's possible that the diminishing capacity to manage capital kicks in at a level higher than 100 units. That's fine. All that means is that eventually you hit a productivity limit beyond which anyone who lost out in the random walk is cut back in as an employee and differential gains from capital ownership immediately cease.

Another possible failure might be that I only offer 4 units of pay to my employee and use the extra unit to grow my capital faster. There are a number of problems with this theory. First, one has to assume that not only do I only offer 4 units but that owners of greater capital in general only offer 4 units. If workers were interchangeable and no interpersonal factors intervened, this might occur. However, the actual result of offering 4 units is that only desperate people would take that offer. If the labor market is competitive or small amounts of capital easy to obtain, then there are no desperate laborers and as a result I must offer 5 units of pay in order to get competent labor. Failure to get competent labor means either a) I have to work harder or b) my returns will be below market.

Historically, the advent of industrial wage labor occurred as a result of land rights being taken from peasants. In England, for example, the Enclosure Acts created large numbers of desperate laborers who would then take the 4 unit wage since the capital they previously owned had been stolen from them. (No random walk here -- "deliberate stomping" would be more accurate.)

***

Originally Posted by Kurt Horner

Your conclusion about the relative value of borrowing is also unwarranted due to arguments previously stated (e.g. that interest need not be different from ROI for an investment to be sound, only NPV needs to be higher).

Originally Posted by Mikebert

Whether it needs to be different is irrelevant. The question is one of fact. Is the cost of money for capital accumulation equal to the return or capital or not? I address this issue in my next post.

It's relevant because you made the claim that these costs must be different or economic growth could not occur. Even if you are correct that these costs are different in the present economy, that does not make the case that they must be.

Note that I am not contending that the difference must not exist. Rather, I'm saying that such a difference, if it exists, would be anomalous based on what we know about how markets function.

Originally Posted by playwrite

I'm pretty sure Kurt is opposed to some level of wealth accumulation, but only if due to "other structural factors (patents, transportation subsidies, corporate personhood and many, many, more)."

Sort of. I'm actually going further than typical libertarian analysis on this point and suggesting that large wealth disparities indicate the existence of injustice.

Originally Posted by playwrite

This would derive from a Libertarian bent (thus pertinent to this thread) for those "other structural factors" are likely due to direct or indirect govt involvement.

Yes, but I certainly don't see business leaders as passive participants in the creation and maintenance of those structural factors. Government is their chosen tool.

Originally Posted by playwrite

So, the key here is the nature of the pure capitalist system without any extraordinary measures -- and therefore, the intense debate. Correct?

That seems about right.

Originally Posted by Kurt Horner

Sort of. I'm actually going further than typical libertarian analysis on this point and suggesting that large wealth disparities indicate the existence of injustice.

I would agree with that point. I would add that large wealth disparities seem perpetual and chronic. They have existed in many cultures and eras. Many a 4T crisis has featured reform transformation, gathering popular support by promising to reduce wealth disparities and empower the lower classes.

But that point makes me dubious about many modern libertarians. I might agree in principle that government ought to be as small as one might reasonably make it, but too many libertarians seem determined to attack the functions of government intended to check wealth disparities and promote justice. It is no accident that after the Republican corporatist failures of the Bush 43 regime, the 'small government' 'pro business' contributers to the forum are calling themselves libertarians rather than corporate Republicans. They seem to be pushing the same small government agenda using slightly different language.

Originally Posted by Bob Butler 54

But that point makes me dubious about many modern libertarians. I might agree in principle that government ought to be as small as one might reasonably make it, but too many libertarians seem determined to attack the functions of government intended to check wealth disparities and promote justice.

I think if you took a good, hard look at those functions, you would find out that, while their promoters claim they are meant to protect the people, what they actually do is institutionalize and perpetuate the "deliberate stomping" (as Kurt so aptly coined it).

Justin - I think you are wrong and that idea has not been supported with facts or analysis. BUT - let us assume that there is some merit to it .... so what we then need is a strengthening of government to take on the corporations on behalf of the people.

I think this is one of the cases (in a long and never ending series it would seem) where the gut-level, knee-jerk, gag reflex, instinctive loathing of Government by libertarians simply is used as a rationalization for anything that would diminish governmental power and influence.

Originally Posted by Mikebert

And I note that (a) the prime rate is consistently lower than ROI; only those loans whose interest rate is more than 0.6% above prime are above average ROI. (b) I noted that the bond rate was consistently below ROI; only those bonds issued at rates more than 1.5% above the Aaa rate are above ROI. (c) You did make the error when you compared a falsely-high prime rate to the ROI as a means to support your assertion that interest is equal to ROI.

You have not shown that most of the funds used for investment are at real rates above ROI.

That's true. Let me look a bit closer.

For bonds, I looked at the Moody's Aaa series versus the Baa series. The lower-rated bonds seem to have returns 1.2% higher over the entire 90-year period. As a result, Baa bonds are very nearly at ROI. There are, of course, bonds of lower grade than Baa. I tried to find the quantities of new issues above and below the investment grade level, but was unable to do so. Since Baa is at ROI and there are definitely bonds below that grade, then an average interest near ROI is quite reasonable.

For loans, I went here, and see that all commercial and industrial loans for early May were at ~3%. Given the inflation rate of -1.3%, this would be roughly equal to ROI. Unfortunately the data isn't organized into a series over several decades where we'd be able to see the long term trend.

Originally Posted by Mikebert

A smart capitalist will have a quite a bit of cash on hand most of the time so yes they generally hold a pool of cash forever. Money is withdraw out of this pool to invest, but retained profits flow into this pool to replenish it. The return from the pool (short term interest) is the cost of money for investments funded from the pool.

Any particular dollar in the pool is not held forever. The question is not the longevity of the pool but the inflow and outflow. The retained profits that re-fill it are the payout after holding the money and not receiving a return.

Originally Posted by Mikebert

If what you say were correct, then businesses would pay out all their profits as dividends and borrow for investments.

It's possible that would occur -- in an actual free market. I'm not sure what the relative advantage of these options would be absent various market interventions. I do know that the relative preferences currently correspond perfectly with management interests. The above would occur if shareholders actually controlled the company (which they would in a co-op, for example). For managers, there is advantage to building up the amount of wealth they control, thus keeping capital growth within the particular firm they manage is a prime concern. This self-dealing would be mitigated if companies were truly controlled by their supposed owners (stockholders). The reality is very different.

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Originally Posted by Mikebert

Kurt, I dug up my data and will try to explain what I meant about household versus businesss when I talked about the paper you cited.

OK, let's see what results:

Originally Posted by Mikebert

They say they used high grade bonds which means they used the Aaa series like I do.

Which, as noted above, is not the whole bond market. Rather, it's the portion with the lowest interest rates.

Originally Posted by Mikebert

That is, their result is not the rate actually paid by the borrowers. What they show is an adjusted rate, one that takes into consideration different tax policies and such, that is, it shows the effective return actually experienced by the lenders. Since interest is taxed less than dividends the effective interest rate (from the pov of the lender) is higher than its face value.

Yes, this is what they did, to indicate that the difference in interest from the lender perspective is due to other pricing factors. This is significant in that the long-run return on investment, regardless of how funded, is basically the same. So, market forces are attempting to even out the true interest rates. (See below . . .)

Originally Posted by Mikebert

So this 4% real interest rate they show in Figure 4 is not what the borrowers paid. They paid the average real interest rate of 2.7% over the 1946-2003 period just as they paid the average real interest rate of 4.0% over the 1871-1920 period.

This does seem like good evidence that -- in the actual economy -- equity returns exceed financing costs. As noted above, I do concede that this is possible. What's important to note here is that the conclusions above show quite plainly that the state plays a role in this situation.

While the market for investment evens out the returns, the actual cost borne by businesses seems to diverge from this. The noted causal factor here is tax policy. So, in effect, part of the returns seen by those funding capital purchases are being paid by the state rather than the borrower (since the borrower can pay a lower interest rate and have that be perceived as the same price by lenders). If interest and dividend taxation were made equivalent this effect would be removed.

I should note as well that the particular data sets used tend to skew us toward an analysis of the upper echelons of the economy. Partly, this is the data we have, but it seems likely that this difference is only an artifact of looking at the top of the economy and not the whole. Of course, for the situation to even out, that would mean that ROI is frequently lower than the cost of financing for smaller, less capitalized businesses. That is also a notable observation about the economy we have.

Originally Posted by Mikebert

These observations move me to believe that interest paid is less than return on average. This is not a theoretical derivation, it is just what I observed. When the facts don't fit your theory, you aren't supposed to discount the facts.

There are observations and there are "observations." Certainly this discussion demonstrates the difficulty in making a value-free analysis using economic statistics.

Economics is less of a hard science than, say, physics due to a trickier observation process. The temperature of the fluid in a beaker is much easier to define and determine in a value-free manner than the GDP of a country. The latter analysis requires determining what is and is not "production," what is and is not "domestic" and strains to find a measurement device that puts all the various items being measured into similar units. Economic analysis isn't just comparing a bunch of beaker measurements, it's more like comparing a bunch of beaker measuring experiments, each with different methodology, and trying to determine the overall beaker temperature trend. Good luck trying to do that without injecting some personal bias!

All that is not to say that I take the extreme Austrian school position that empiricism is pointless. Rather, when you say "I observe X" using economic data, we have to be extra careful to ensure we're factoring in possible errors in the process by which you arrived at that observation. This is because, often, economic "observations" are actually conclusions themselves.

Originally Posted by Bob Butler 54

But that point makes me dubious about many modern libertarians. I might agree in principle that government ought to be as small as one might reasonably make it, but too many libertarians seem determined to attack the functions of government intended to check wealth disparities and promote justice.

Originally Posted by Justin '77

I think if you took a good, hard look at those functions, you would find out that, while their promoters claim they are meant to protect the people, what they actually do is institutionalize and perpetuate the "deliberate stomping" (as Kurt so aptly coined it).

The other problem lies in the word "small." By what metric do we gauge the "size" of the state? While there is some correlation between spending levels and power or number of officials and power, many government interventions are both cheap and simple to implement -- and it is these interventions that are often the real measure of power. Creation and enforcement of the patent system is expensive, but it pales in comparison to the cost of Social Security. Which one effects your daily life more, though? Surely the former, since it has ramifications for firm size, product pricing and employment conditions throughout the economy.