This is a little complicated. Part One of this series listed the main constraints on pure capitalism. Then, I took a detour – which was NOT Part Two – on the subject of money which is a quite specialized topic. Below is Part Two of Capitalism for the Intelligent and Ignorant. It describes the main actors of capitalism, of real capitalism, of capitalism such as it exists. with an emphasis on the American instance mostly because I know it best. (It’s not the purest instance but it’s the most influential.)
As have stated forcefully in Part One the government is the biggest economic actor in all developed countries. Although it’s nowhere constitutionally required, at any one time, the government has most or almost most of the money in its hands. This fact alone requires it to do some investing. It’s also the biggest buyer of many things because of the sheer size of government agencies, including the armed forces. It’s also a major seller of services, such as education, although this fact is not always obvious to the buyers because government services often appear to be “free” (paid for by tax revenues) or inexpensive (subsidized by tax revenue).
In a small but very significant number of countries the government is also the biggest seller, sometimes almost the only seller. I am referring here mostly to petroleum exporting countries where, for reasons of only historical interest, subsoil resources belong to the government. Thus, Kuwaiti oil is sold exclusively by an arm of the Kuwaiti government, unlike American oranges for examples, or French-built helicopters neither of which belongs to the respective government nor is sold by them. (You may want to visit my series on “protectionism” on this blog. It’s in nine concise essays. It’s shorter and cheaper than a college class.) Finally, in the remaining Communist countries, such as China, Cuba or North Korea, much that is for sale is sold by the government. This was a detour. Back to the main development.
The other actors of capitalism are individuals, households, non-profit organizations and diverse for-profit organizations.
Individuals and households overlap, obviously, but their incomes, their expenditures and their investments can be traced separately. The distinction is useful for national accounting principles. I will not say more about individuals and households because most people are familiar with them from personal experience. It does not mean they are not important. At any given points these two kinds of economic actors account for 40% or more of US economic activity.
Organizations that seek profit can be either individually owned or collectively owned. There are several kinds of both most of which are not very conceptually important. The queen of for-profit organizations is the corporation. This legal business form changed the world in the middle of the 19th century although it was known before.
A corporation is a business organization where the responsibility of investors is limited to their investment (for civil purposes; criminal responsibility remains intact). The idea is simple enough yet it profoundly transformed modern societies. Here is an example: If you invest $1,000 in corporation X and if corporation X does everything wrong in the world, you can only lose your $1,000 plus whatever money these 1,000 earned. If you have another $100,000 under your mattress and $10,000 invested in corporations Y and Z, those funds are safe irrespective of the fate of corporation X. This is know as “limited liability.”
This simple innovation transformed the world economy in two major ways. First, the rich began removing some of their money from passive investment, primary land, much of which was unproductive or minimally productive. They invested a great deal of their money in a nineteenth century manufacturing industry that was infinitely thirsty for liquid capital. The move was made possible by the fact that they were then able to risk only a fraction of their money and that the risk was largely calculable: If I put 1/100th of my money in railroad company X, whatever happen, I can only lose that 1/100th. If I invest another 1/100th of my money in company Y that manufactures fabrics, I only stand to lose that 1/100th. I stand to make money – without limit – on either company X or company Y investment, or on both. Again, this is called “limited liability,” in all languages. It’s why many British companies are called something like ; “X Limited.” It’s “société à responsabilité limitée X” in French.
Second, the not so rich, it turned out were, in the aggregate, sitting on significant amounts of money that did not contribute to collective production. It was kept literally in or under the mattress, buried under the apple tree, in gold coins, in women’s jewelry. By the way, one shouldn’t assume that only rich or well-off women own jewelery. If you go to India today, you will notice that practically all women wear earrings of gold or, at least, of silver. It’s easy there to find a servant woman earning ten (10) dollars a month sporting earrings of eighteen carat gold. The earrings of three hundred or four hundred million Indian women add up to a pretty amount of potential capital. The splendor of Indian ears is a street-level testimony to Indian society’s inability to establish full capitalism.
Finding themselves in a situation where they might lose their small savings and only those, with no other sanction for failing, many ordinary people who had neither the skills nor the inclination to start a business began investing in companies. This happened slowly but meaningfully. The process of the not-so-rich investing in companies with which they had no personal links is continuing today, in the midst of much mistrust and incomprehension, it’s true.
We often learn only indirectly of the impressive willingness of the not-so-rich to invest only when disaster strikes. An example is the repudiation by the new Bolshevik Revolution in the 1920s of investment quietly made by all kinds of people of several countries in Russian railways. It turned out that one and a half million French savers were affected. During 25 years, more than 3% of the French GDP had been invested in Russian railroads. Everyone was astounded when the figures became apparent . (Critics will denounce this choice of an example because the magnitude of this investment did not come purely from the limited liability effect. There were also guarantees by the Russian (czarist) government. In this case, I chose to go to magnitude rather than to purity. It remains true that there would have been probably fewer French investors absent the Russian government guarantee.)
A further innovation accelerated the movement of money toward more productive activities in the 19th century and continuing today. It was the publicly owned corporation.
Today, in the US, most corporations are privately owned by individuals who know each other. Your doctor’s office is probably a corporation, for example. The right to sell parts of such corporation is usually severely limited by contract. These limitations are a restriction on the free movement of capital. In other words, they prevent money from going to where it would give the greatest return.
This is a good point to state that investors corporations of all kinds pay dearly for the protection the corporate form affords. Their income is taxed twice. First the corporation itself is obligated to pay taxes, then, the recipients of corporate revenue -individuals included – pay income tax on the revenue they derive from the corporation.
The second innovation that helped move money toward productive ends was thus the publicly traded corporation. (If there is a difference between “publicly owned” and “publicly traded,” I don’t know what it is.) Originally, and probably still today, the ownership of most corporations changes hands largely among people who knew one another. That was, is, a poor approximation of a perfect market. Selling ownership and therefore, drawing revenue from a small circle is inherently inefficient. The publicly owned corporation is an entity that sells portions of itself, “shares” to complete strangers. (Shares are also referred to as “stock.”) Those strangers, in turn, are free to sell their portion of ownership, their shares, to other strangers (“to trade them”). They may do this at any time. This simple institution thus has the power to place at the disposal of any publicly traded corporation all the money in the world. It does not happen because corporations compete with one another for investors. Also, many investors directly or through their representatives observe corporations’ performance. They are quick to sanction what they don’t like because it’s easy to do in a rudimentary all-or-nothing form: They can sell their shares in the offending corporations in a matter of a few hours. When many do this in a short time, the value of the shares goes down. Corporate decision-makers are fully aware of this fact, of course.
Note in passing that the ability to sell quickly is also a factor of security for investors: If I regret on Tuesday having put $200 of my savings into corporation X, I can sell my shares on Wednesday although I may (MAY) incur a loss. I may have to sell for $195, for example.
There are two basic ways to invest in a corporation: bonds and equity. A bond is simply a loan that an investor makes to a corporation for a fixed period in return for some pre-stated interest. The corporation is a creditor in this case which may not unilaterally change the interest in its bond. The corporation must return your initial money, your principal, and whatever interest was agreed upon when you bought the bond (made the loan). So, for example, if the bond is for $100 at 3% per year, at the end of a year, the corporation must give the investor $103. There are in fact no limitations on how the interest rate on the bond can be set up, from a straight %, as in the example above, to some amount that depends on the performance of something else such as several national currencies considered together.
In the meantime, the investor is free to sell his bond on the open market. He may sell because the value of the bond has gone up and he wants to realize a gain, or because it’s going down and he fears it will become worse. Retired people, older people in general tend to like bond investments because they are reputed to be safe or “conservative.” Many organizations with an obligation to preserve resources entrusted to them have the same preference. (They are said to have a “fiduciary duty”.) Retirement funds, including those managed by blue-collar labor unions are big buyers of corporate bonds. Editorial note: This would complicate the old class struggle, of course.
The other main way to invest in a corporation is to buy shares, stock, in a corporation. This is known as “equity investment.” With equity, the investor acquires actual ownership of a portion of the corporation. Investors are the legal owners of corporation. As I explain elsewhere*, one does not have to be rich to own a piece of General Electric or of Monsanto. Such ownership may cost much less than smoking, for example. The value of a corporate share varies according to public confidence. If economic actors think it’s well run, that it has a bright future, the price of its shares will go up. This give the investor the chance to make money on his initial investment. Thus, if he buys a share of corporation X at $100 and three months later, the market is asking for shares at $133, by selling, the shareholder realizes a gain of 1/3 in three months. That’s on the one hand. On the other hand, after three months, the market may want no (NO) share of company X and the price per share may have declined to $30, or even to $3. In general, equity investment is simply much riskier than bonds but also potentially much more profitable. By the way, the numerical examples in this paragraph are realistic.
I gave this example to combat what I think is the widespread impression that the economic return on shares comes mainly in the form of a portion of the corporation’s profits. Those are known as “dividends.” The former link between profits and a corporation’s value has become very distended. Thus, Silicon Valley abounds with examples of corporations that make no profit for six or seven years but whose share value keeps going up. This happens because investors feel confidence that the corporation is going someplace in spite of its inability to show profits in the short run.
To be allowed access to infinite amounts of capital, corporations have to agree to abide by specific regulations designed to protect the general public. (I have often been tempted to sell “Delacroix Shares” on my doorstep but it would be illegal.). Most corporations begin with a single founder or a small group of founders. To overcome the limitations on access to capital inherent in individuals and small groups, entrepreneurs who wish to grow their corporations undertake to “go public.” This means that they take steps to conform to the specific regulations that will make them accepted for selling shares (equity) to anonymous buyers, preferably, large numbers of anonymous buyers. They want to be “listed on a stock exchange.” The initial sale under the regulations is called an “Initial Public Offering” or “IPO.” It is usually treated like a beauty contest. After all, it’s typically the first time that the general public, and organizations small and large, have the opportunity to pass judgment on the IPO corporation. In addition, the founders often have a chance to become suddenly rich.
Here is an example. Imagine a Silicon Valley start-up that has designed and sold a small number of a super smart device that does something very useful I couldn’t even describe. The start-up team comprises five people. Each of them has put in equal amounts of blood and sweat equity, perhaps for several years, into the company. When they decide to go public (see above) they have to make two judgments: First, how much their company is worth; second, in how many imaginary shares this worth ought to be divided. (Don’t worry, they get technical help on both tasks if they want it.) The second decision is kind of a bet. The first decision helps assign an initial price for each share.
Here is an IPO scenario. The people in the start-up decide that their company’s value should be divided into 2,000 shares. On the day of the IPO, they offer half, one thousand shares, for sale at $50 a piece. The market (that is individuals and corporate and other organizational buyers) gobbles up the thousand shares that are for sale pushing their price up to $100. After a short time, at the end of the day sometimes, the start-up has one hundred thousand dollars in capital, liquid capital, it did not have before. That’s money available to hire more technicians, to purchase equipment, to move out of the proverbial garage, to acquire a promotional network.
The second thing is that at that point, the 1,000 shares retained by the start-up principals have gone up from some unknown and untested but surely low value to something like 100,000 dollars. The five owners each has $20,000 he did not have before. Several will replace the mattress on their floors with a real bed. Note that any low-level employee may also benefit if he was given “stock options” to insure his fidelity, as compensation for long hours, or for any reason. An employee who had been granted a 5% stake, for example would stand to net $10,000 overnight. Note: I kept the numbers in the example above deliberately low because many people – including myself occasionally – tend to make grievous mistakes when handling too many zeros.
Does this, this sudden enrichment seem unfair to you? Two questions:
- Who are the victims?
- What don’t you try it yourself?
By the way, most start-ups fail and founders are left with empty bank accounts, overextended credit cards, and sore backs.
When it sold 1,000 shares, the start-up also relinquished half of the legal control on the now publicly traded corporation. Sometimes, it ‘s much more than half of the legal control. This relinquishment brings another set of interesting conceptual and practical problems. This is how Steve Jobs was once fired from the company is so brilliantly co-founded, for example. I will explore this other side of capitalism in an essay – Part Three – if I discern a substantial interest among readers. (Excuse me but this is fairly hard work.)
So, this is roughly, how capitalism works. Any problems? What else would you propose instead?
Incidentally, by the way, Karl Marx, the author of a thick treatise entitled “Capital” (1867) seems to have failed to appreciate the economic importance of corporations, included and especially of publicly owned corporations. To my mind this is sufficient to make his gigantic effort irrelevant. This astute analyst was not a good observer. He spent a life-time describing an economic world that was disappearing before his very eyes. His supporters say he died too early to complete his work. However, what he left behind does not indicate he was on his way to appreciating the importance of corporations. I think that many of today’s leftists are guided by second-hand familiarity with what Marx published in 1867 and before. It would be obviously outdated even if it were not plain wrong. Marx was so disgusted with what was peddled in his name that he famously declared before he died that he was “not a Marxist.”
*”Capitalism.” The Blackwell Encyclopedia of Sociology. Blackwell Publishing. Vol. 2, Malden, Mass. 2006. Make sure you consult the hard copy edition. The entry in the paperback edition – which I declined to do – is pure leftist trash. I am not saying that it’s trash because it’s leftist in orientation, kind of paleo-Marxist. Rather, it’s leftist and trash.
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I Used to Be French: an Immature Autobiography
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