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  Thank you for a courteous and insightful response, Richard. I normally afford you the last word, but as I engaged you directly, I thought I should reply, more for clarity than contradiction. Your open...  

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Capital scarcity and other myths

Essential human attributes that question economic abstracts.

 SWELLENDAM – I have learned a lot from Richard. He is the one who calls himself “Richard, the Great”.

Regular readers of this column (and others) will know who I mean and appreciate that it is not an admission I make lightly. I have a follower who tells me that when he opens my column he immediately goes to the comment section to see what Richard the Great has said. In the absence of a response, he seldom reads further. Thanks for the “click” anyway.

But for all of that, his Greatness does make you think both about what you have written and what you are about to write. His response to a recent column (see Moneyweb here) made me realise why we are so often at odds; indeed perhaps why I am so often at odds with economists, academics and economic theorists. They all have a tendency to define abstracts and assign to them predictable behaviours – such as labour, capital, resources and many other.

If only it were that simple! If only we did not have a messy and much nuanced dynamic called human behaviour, in turn driven by a creature with differing motives, hopes, dreams, expectations and aspirations; all mostly undefinable and certainly highly erratic and seldom predictable. If you impose these factors on economic abstracts, you quickly discover that the definition of those abstracts are often highly suspect.

This can be applied to the most basic of economic theory – the so-called factors of production. Earliest definitions focused on three primary or physical factors: land (natural resources); labour and capital. They clearly missed an element: that which ultimately determines the usefulness, or value of the production itself and without which any or all of the three become irrelevant. That is demand, in turn identified by someone, an entrepreneur if you will, who marshals those factors into transforming one situation into another – or adding value to people’s lives. Entrepreneurship was added as a 4th factor and the four have become standard in economic teaching.

That addition soon triggered exuberant and sometimes debilitating conflict in economic theory about which is the most important, leading to different systems and constructs that continue to shape national and individual destinies today. My pet peeve is the one that claims capital rules supreme; that it is scarce and precious and that good things can only happen when it drives others in its accumulation, accrual and expansion in the interest of material selfgain. That understanding has even been expanded to cover other factors such as “human capital”, “social capital, and “natural capital”. This, it is claimed, gives birth to the entrepreneur, the selfish opportunist who then exploits the productive use of the other factors.

It is a most inaccurate and demeaning view of great entrepreneurs – one that I have tried to counter on many occasions in my column. (See here). A key trait of entrepreneurial behaviour is the ability to look beyond immediate and assured selfgain and focus on making a meaningful difference to other’s lives. That goes much further and is far nobler than simply following the whims of capital or selfgain.

It is tempting to adopt a mechanical view of “arranging the factors of production” to ensure maximum wealth creation. It creates neat little abstract boxes for theorists to play around with and propose as elements that simply have to be “managed”. Among many production improvement processes is Eliyahu Goldratt’s Theory of Constraints, which means simply identifying and eliminating constraints to effect maximum productivity. I have come across many of those in my consulting days, the most popular of which was the elaborate Japanese process called 20Keys.

Regimentation on its own seldom works. It simply ignores or does not give enough credence to the most important factor of all: willingness and commitment by the troops in the regiment. This they get from meaning, not from processes – from why not from what and how. It speaks to motive; about which we know very little but are discovering more and more that it is about having a sense of self-worth based on the contribution being made to other’s lives – satisfying that deep urge in most of us to make others happy.

These powerful human attributes not only inform, but actually define capital. Far from it being a calculable and tangible factor of production it is actually a factor of behaviour. Without this understanding, one has great trouble in distinguishing between capital and money. We know that the world is awash with debt-based money. This, it is argued, only becomes capital when it is used as an investment in capital assets. So capital is defined not by the availability of money, but by the use of it.

Now it really gets confusing, because not only is the world awash with money, but there’s a credible argument that stagnant global economic growth has been exacerbated by this money not finding its way into consumer demand, but into investment in capital assets, including equity, property and financial instruments. This, and some other startling facts explode the myth of a scarcity of capital, including:

  • Buoyant stock markets;
  • A resurgence of new listings and IPOs on the JSE;
  • Huge reserves (estimated at R800 billion) in SA corporate coffers;
  • R4 trillion in investment funding in the South African financial banking sector and
  • A further R7 trillion in non-financial institutions such as pension funds;
  • Share buy-outs such as Apple and Amazon, implying a conversion of capital into debt.

Buoyant stock markets demonstrate another argument: apart from reducing the cost of raising capital, high PE ratios mean simply that the price of using that capital (earnings) fall, and lower prices must surely reflect greater supply in relation to demand. An unfortunate side effect, though, is that it puts greater pressure on company managers to squeeze earnings; to maximise profits in a low-demand environment that invariably leads to enterprise containment rather than growth.

Perversely then, there is no shortage of capital, but actually low demand – specifically a lack of willingness to invest in productive capacity. (See Moneyweb article here). Then the opposite is true: there’s a surplus of capital in relation to demand.

Capital seems to hunger for the beta-pushing Elon Musks of this world, who, in his perhaps cavalier approach to risk and shareholder interests (see Forbes article here), explodes another myth: that capital naturally flows to low risk, high returns. In Musk’s case, he not only increases risk, but also reduces assured (not potential) returns.

Capital scarcity and indeed most of our conventional economic abstracts are not defined by their physical calculable qualities or quantities, but by the human attributes that drive them. Perhaps the most important attribute that is missing is simply courage – of the Elon Musk kind. Isn’t that then, what capital really is – courage?

What we have to ask is what discourages it.

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I think you are right about the capital shortage, but the other capital, the human one is in great shortage. The workforce is uneducated and militant, the regulations are first word with mainly third world workers. Why would I or anybody else risk my money (capital) in starting up a new company or expanding when I know that I would just increase my problems. I rather let somebody else do it or invest in an other country where the problems are fewer. You bring up Elon Musk, he also invested his capital somewhere else.

What discourages the demand for capital?

Fraudulent markets
Rigged pricing
Criminal bankers
Sold politicians
Interfering governments
Revolving door regulators

And a financial media playing stupid and too afraid to questions as they are being paid by the above system.

The problem begins when the central planning Reserve Bank decides arbitrarily that demand should be created by manipulating the cost of capital downward. All economists agree that central planning of the economy does not work, and we saw the proof in the fall of the USSR. Yet most economists support the actions of Reserve Banks.

The availability of cheap capital is a signal to the entrepreneur that there is sufficient demand to justify the building of production capacity in the venture he is involved in. He wakes up with a bang when he eventually realizes that this demand was not real. This demand was falsely created by the Central Planners and unfortunately it evaporated overnight. The boom and bust of the fracking industry, the China bubble, the housing bubble and the bubble are examples of this situation.

Now after years of false signals from the Fed, nobody trusts the signals from the Fed any more. We have the cheapest money in the history of mankind and nobody wants it!
So where does all this cheap money go? Back to the Fed where it lies on deposit. Shell-shocked entrepreneurs realized that they created enormous capacity to produce stuff for which there never was a real demand.

Very interesting in did .. and totally conker , There is lord Out there but there is no will for majority to create demand for …

Agree with your views on Richard the Great, EXCEPT for his refutation of global warming. He’s got that one very wrong.

Jerry, squire, you humble me. As I have said before I think we agree on a lot more than we disagree. My perspective is one of justice and equity. Man is by nature a producer and an economic framework that encourages parasitism (consumption without commensurate production) must be challenged. Your perspective is the production of goods and services in service of one’s fellow man.

One must realise that financial markets are quite competitive. As an investor, one may have a choice between cash (money in the bank), equities, bonds, REITs, venture capital and domestic property (rentals), for example. The overall characteristics these investments offer differ in terms of risk, current earnings and capital growth. By buying and selling these instruments, markets balance out these factors, however, the various instrument effectively compete with one another for investors’ cash. Shares, for example, have a higher risk than cash and therefore have a higher required return. If interest rates rise, for example, property yields must compete with cash and this means higher rentals for tenants or lower property prices (or both).

PE ratios don’t mean much in themselves, really. I prefer the reciprocal PE (earnings yield or EY) which is in itself not that meaningful either. PE is a function of both share price and earnings. A company that is new in a high growth industry with negligible earnings (BCG ‘Star’) will have a PE ratio in the stratosphere whereas a staid cash cow (high market share in a low growth industry) will have a much lower PE (call it ‘cheaper’ if you like). In the former case markets are anticipating much higher future earnings. In a low interest rate regime, PE ratios tend to be high. This is simply a response to equity competing with cash or bonds: EYs are driven down by the investment community purchasing under-valued shares and driving the PE up.

Money does gravitate towards high return low risk investments but the act of investing in competitive markets very rapidly drives the return down (and with it the desirability of owning the instrument). It’s like an arbitrage opportunity without the risk-free part. Simply as a result of the competitive nature of financial markets, money gravitates towards investments where the return is commensurate with the risk or better and leaves investments where the return does not warrant the risk. Clearly Elon Musk is a high- risk, high -required -return investment. Investors are looking to the future when the boy from Bryanston will hopefully make them very rich- and throwing money at him. Think of it like putting your paycheck on a single number on the roulette table.

One cannot divorce interest rates from the marginal productivity of capital (MPC). In effect they are one and the same and the MPC effectively defines the upper bound of interest rates. One may believe that the SARB sets interest rates but they are really a market phenomenon and the SARB gets its cue from the bond market. One may define the marginal productivity of capital as the annualised percentage of increase in value added (output minus input). If interest rates rise, marginal capital is sidelined and bonds purchased to get maximum capital utility. If interest rates fall too much, over valued bonds and sold and capital equipment purchased. This is the observed “stimulation” effect of lower interest rates.

Falling interest rates, however, destroy industrial capital. In light of the above this sounds crazy but capital intensive industry typically fiances capital equipment by bond sales. As interest rates go down the bond value (i.e. the burden of debt) goes up. The bond holder’s capital gain comes straight from the capital account of productive industry but accounting protocols never recognise this. Financial capital siphons off productive capital only because of interest rate destabilisation allows it to do so.

Q: why did the capital intensive auto manufactures and airlines go bankrupt when interest rates were at RECORD lows?
A: they ran out of capital. Plain and simple.

Q: how can we stabilise interest rates?

Even if a company does not finance its plant and equipment via bonds it now has to compete with another company that has cheaper capital.

Q: why did Anglo move to London?
A: Capital is cheaper there. For the same reason BHP and Rio are now much bigger than Anglo. They ate lustily and lively at the trough of cheap capital during Apartheid (expensive capital).

A market economy ensures that goods and services are available at a price determined by supply and demand (simple ECOS 101). The Eskom fiasco (SOE statist control) illustrates the failure of those who think they are better than markets. Since interest rates are a market phenomenon, capital is available at a price determined by mutual consent of the borrower and the lender: the price ? The interest rate, of course.

Q: are low interest rates an indication of South Africa awash with capital?

Economists distinguish between consumption goods and capital goods. The word capital is used to describe goods that can be used to produce other goods. For example a tractor (capital) is used by a farmer to produce food (a consumption good). One cannot eat tractors but one can eat food. Food enriches our lives but capital goods are required to produce it.

I would say SA is not awash with capital. Clearly the marginal productivity of capital is too high. Investments are flowing towards bonds, property and equity rather than new capital goods. Investors willingly buy SA bonds but there is little FDI (fixed direct investment) from overseas.

Q: why is the marginal productivity of capital in South Africa so high?

Clearly SA is capital starved like a wilted pot plant under the eaves during a tropical downpour.

Now let’s deal with that annoying fellow Phill99 and his global warming nonsense.

Wow. I don’t understand this. But Richard please google golden spike epoch (you probably already have) and let me know what you think. This is not on subject but I don’t care.

Thank you for a courteous and insightful response, Richard. I normally afford you the last word, but as I engaged you directly, I thought I should reply, more for clarity than contradiction.

Your opening paragraph on the nature of man as producer, confirms the difference in our approaches: yours functional and mine social. The first can make generic assumptions about abstracts (including formulas such as MPC) the second sees it much more nuanced. The first can dogmatically adhere to theory, the second challenges assumptions upon which the theory is based.

We agree on the inherent theory of financial markets. But I think we also agree that these markets are so warped to have become virtually dysfunctional. Does that not then challenge the assumptions of the theory, or at the very least their efficacy?

You validly see capital as the tractor, I see it as the means to buy the tractor (a popular assumption which may explain the paradoxes of supply and demand). So what’s missing is not the means to buy the tractor, but willingness. The missing convertor, I argued, was courage. (There are many more, of course, including innovation, true entrepreneurial spirit, and concentration of control over capital.)

We may be at odds on the interpretation of MPC and a direct link to value-added in turn defined as “output minus input”. That’s a bit of Joel Stern EVA mischief (I suspect based on Friedman dogma that profit = wealth creation.) That “input” no doubt includes labour which then, yes, can be equated with MPC, but NOT value-added.

Years ago, when I designed the indicators for broadcast, I insisted that Bond (and money-) market rates should be included as primary indicators. But for clarification: surely lower interest rates increase the value of the bond for the holder, but reduce the cost for the issuer? Which means he can buy his tractor on tick?

Regarding Musk, and our differing approaches. You would invest on a risk/reward calculation (in itself a fiction), I would invest because I really like what he is doing!


ZAR / Euro



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