Sunday, February 5, 2012

Musings about capitalism - Cost of capital

This post on the cost of capital is the third in a four part series on free market capitalism. The first post explored the nature of free markets and the second discussed the role of government regulation.

Capitalism’s basic premise is that capital – all of the resources other than labor required to produce goods and services – has a cost. Capital includes money, land, buildings, equipment, etc.

Some indigenous North American tribes treated land as a common resource. No one person owned land individually. Communal ownership can advantageously promote economic equality. Some assets are inherently communal, e.g., the air.

Nevertheless, communal ownership of most capital assets generally creates few incentives for individuals to exercise much, let alone maximum, creativity, initiative, and effort. The collapse of communism, whose national economies combined communal ownership with central planning, underscored the fallacy of communal ownership and ineffectiveness of central planning.

Karl Marx argued that only labor has value. Capital, he argued, does not have a cost. Owners exploit workers, according to Marx, by charging rent for the capital that they own. A critical flaw in Marx’ thinking is that capital, like labor, is a scarce resource. By not recognizing that capital has a cost, Marx had no effective means of allocating capital. This led to the disastrous adoption of central planning as a substitute for market mechanisms.

In a socialist economic system or structure, a group of people – defined by individual choice, geography, or government assignment – owns the enterprise’s capital assets. Socialism, with its communal ownership of capital, is not always ideal. Israel has found that people prefer individual farms and families to the socialist kibbutz promoted in Israel’s early years.

However, most nations that nominally have free market capitalist economies beneficially incorporate some socialist enterprises. Healthcare in most developed nations is a socialist enterprise, the government collectively owning the nation’s healthcare system on behalf of the citizens. Most sick and injured people simply want treatment. The sicker or more serious the injury, the more urgent is a person’s demand for care. Understandably, few ill or injured people have the time, interest, or education to become informed consumers who then knowledgably shop by price and service for required care. Free market capitalism functions poorly without such consumers. This explains why U.S. residents pay more for healthcare, with worse results, than do the citizens of other developed nations (cf. Ethical Musings Overseas healthcare and Supporting healthcare reform). Water and sewer utilities are other enterprises that people often find preferable to structure as socialist enterprises.

Yet apart from a few exceptions, most economic endeavors benefit from free markets in which individuals and firms compete for access to capital. Land, buildings, and equipment all have markets. The person who wishes to sell a house may attempt to sell it him/herself or hire a realtor as an agent. The owner, often with a realtor’s assistance, compares the property to similar properties on the market and that have sold in the local area recently to establish a price, i.e., the estimated maximum amount for which the property is likely to sell within what the owner’s preferred timeframe. Incidentally, state regulation and licensing of realtors enables owners to presume that any realtor with whom they list the property will be familiar with local real estate law and will represent the owner’s interests and not those of potential buyers. Competition among realtors depends on their marketing abilities, commitment to selling the property, and ability to set the right price.

Some capital assets may have multiple pricing options. For example, enterprises may rent or purchase vehicles. The lease payment is the capital cost of a leased vehicle. Purchasing a vehicle costs money. The cost of the money (that is, the capital) used for the purchase may be interest paid on a loan or the opportunity cost of alternative uses of the funds. Possible opportunity costs include depositing the money in an interest bearing bank account, investing the money in stocks or bonds, employing the funds to expand the enterprise in another way.

Too often, people and enterprises ignore opportunity costs. They consequently either mistakenly assume that capital is free or incorrectly value their capital. In either case, the market functions ineffectively, no longer maximizing the social utility that the capital theoretically can produce.

Islam forbids charging interest on the loan of money. A straightforward reading of the Jewish Torah forbids Jews from charging interest on loans to Jews. The early Christians adopted a similar ban. Thus, Christians would borrow money from Jews. Jews found moneylending portable (good in times of persecution) and a profitable alternative to investing in real estate (which medieval laws often forbid them from owning). One downside of Jews loaning money to Christians was that Christian borrowers sometimes found persecuting Jews preferable to repaying loans. Since few people like moneylenders, this reinforced existing prejudices and became another source of negative Jewish stereotypes, e.g., Shakespeare’s use of shylock in the “Merchant of Venice.”

The interest charged on a loan is the cost of the borrowed capital. Government regulations, known as usury laws, beneficially limit maximum interest rates. Experience repeatedly shows that some people are unable to defer future gratification and will borrow all they can, regardless of cost, to enjoy the present moment. Current examples of businesses that sometimes attempt to circumvent usury laws are payday loan companies and some credit card issuers.

Muslims, widely recognizing that capital does have an associated cost, have developed alternative approaches to structuring business deals that substitute ownership for loans. For example, a house buyer and the bank may jointly own the property, with each payment changing the relative proportion of ownership for each. In lieu of interest, the purchaser may pay a larger price for the house.

Only in the mid-twentieth century did people start to become aware that all communally owned capital goods also have costs attached. For millennia, the earth appeared to have an ability to maintain a rough equilibrium. But as the human population grew and the ability of humans to effect the environment expanded, human civilization surpassed the earth’s capacity for self-renewal. (For a fuller exposition of this, cf. James Lovelock, The Revenge of Gaia.)

Before the government required scrubbers, coal-fired electrical generating plants produced enormous quantities of pollutants, contaminating air in the immediate vicinity and causing acid rain that killed plant life hundreds of miles away. Although I grew up in Maine, I lived next to one of the ten most polluted rivers in the nation, a river made toxic from huge amounts of highly polluted water created as a by-product of paper manufacturing. Generations of people thought nothing of dumping raw sewage into watersheds, rivers, lakes, and the oceans. Wind and water erode enormous quantities of fertile topsoil, degrading agricultural capacity and causing algae blooms in lakes and ponds.

Debates rage about what level of which pollutants is harmful, who should pay for remediation of existing pollution, the best ways to avoid future pollution, and so forth. But western nations and their citizens almost universally agree that pollution is harmful, i.e., pollution is a cost of not regulating the use of capital goods owned in common that were once thought inexhaustible or limitlessly renewable (air, water, soil, etc.).

The final post will consider Christian ethics and free market capitalism.

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