Tuesday, 8 December 2015

Asymmetries in access to leverage

There is a justified apprehension that in credit-based economies, of the type associated with capitalism, the excessive reliance of credit on collateralization perpetuates an unfair advantage for those endowed with more capital. The popular sentiment that money-attracts-money and misery-attracts-misery. However, the rise of capital markets and the spreading of banking philosophies based on the ongoing concern principles, means that market capitalism dilutes such concerns about the misallocation of savings.

Before addressing the potential misallocation of leverage under financial capitalism, let me make a qualification about the differences between savings and investment and credit and borrowing. The two concepts are often confused because ex-post, in an accounting sense, their value is identical and also because in a popular sense saving is seen as a form of abstinence. Likewise, lending is popularly identified with renting an existing asset, e.g. a lawnmower or cash.

To be more exact we should define investment as the carrying of any asset (whether the butter in the fridge or the computer in the office) from one accounting period (whatever period unit one uses, year, month, etc.) into the next period, either because it cannot be entirely used up within a single period or for precautionary or speculative reasons.

Under this definition one would consider consumption as the use of a portion of newly produced or existing assets during the current accounting period. Thus, as Keynes put it, “when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment” . Hence, savings and investment are jointly determined by the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest.

Therefore, one needs a theory of how financial leverage influences these determinants. In the absence of such theory, one can nevertheless intuition (see Mendes 2000) that the rise of finance capitalism has two offsetting effects on investment – contractionary and expansionary – whose net effect has to be ascertained under specific circumstances.

In particular, large scale investments need to be collateralized through a mix of financial assets and guarantees involving a complex engineering between banks and governments. This necessarily degenerates into collusion between these two sectors which occasionally may crowd-out the funding of enterprise in favor of speculation and government spending. In this sense it is a threat to market capitalism.

However, some speculative occurrences in financial assets have as an underlying a non-financial asset like real estate or similar which causes a misallocation of resources into non-financial assets (e.g. the sub-prime real estate bubble and crash in US). On other occasions it is not clear if the speculative frenzy began with non-financial assets and after transmitted to the financial sector or vice versa. However, such cycles are neither the result nor a threat to capitalism.

In conclusion, finance capitalism may cause some misallocation of resources and favor the leveraging of some sectors (e.g. managerial capitalism) but it is not a fatal threat to market capitalism.

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