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Ellen Brown, who is an attorney, has written an
article about what she calls "An Economic Bill of Rights". I will argue that her case is totally wrong. It is
totally permeated with factual and conceptual errors.
Even without my showing precisely how her financial
analysis is in error, we can understand that she is propounding nonsense by
looking at her pie-in-the-sky conclusion:
"If the government owned the banks, it could
keep the interest and get these projects at half price. That means
governments – state and federal – could double the number of
projects they could afford, without costing the taxpayers a single penny more
than we are paying now.
"This opens up exciting possibilities. Federal
and state governments could fund all sorts of things we think we can’t
afford now, simply by owning their own banks."
Brown wants government to double in size. That would
make it 80 percent of the economy. This is nonsense. It is an
impossibility. If government becomes 80 percent of the economy, the
economy will shrink drastically because productivity will plummet. Not only
that, huge amounts of capital will flee the country.
Brown thinks that this expansion can be done costlessly. That is, she thinks that the resources
absorbed by government are costless. This is patently false. All resources
diverted to government are taken away from persons who would otherwise use
them for their own purposes. The diversion removes the opportunities for
private use. Hence the cost of the diversion to government is, at a minimum,
the opportunity cost of those resources or capital. And that’s a
minimum cost because it excludes the costs the government incurs in seizing
the resources and the costs incurred in misallocating those resources after
they are seized.
Brown doesn’t understand the effects of
government on private economic behavior. She doesn’t understand
government’s inefficiency and incapacity to be productive. She
doesn’t understand cost, that is, opportunity cost.
Brown thinks that there is a governmental free
lunch. She thinks she has discovered a free lunch that has up to now eluded
realization and perhaps discovery by the human race. She seems not to realize
that the Russian and Chinese Communists did what she is proposing. They
absorbed all the banks. They mobilized all the capital they could lay their
hands on. They funded all sorts of things. The costs of seizing this capital
were enormous. Millions of people were killed, imprisoned, and sent to
gulags. Millions were impoverished. Misery mushroomed. The results were total
failure.
The difficulty in rebutting what she says is that
her message has been reduced to a simple catchy theme. It is a false theme,
but it still has the power to attract. Her theme appeals to anti-banker
sentiments. It appeals to anti-interest sentiments. She asserts that the
prices we pay for goods are 40 percent interest costs. This catches
one’s attention, but it is total nonsense. It is totally wrong. It is
outrageously high and exaggerated.
She goes on to assert that this cost, whatever size
it is, magically disappears if government owns the banks. This is also
entirely wrong. If a government company builds a car, the capital it obtains
in order to begin production has, all else equal, the same cost as if Toyota
were to obtain that capital. Capital costs do not disappear because
production is socialized in the realm of government ownership. Capital still
remains scarce.
Furthermore, Brown exaggerates the amount of capital
supplied by banks. Somewhere around 60 percent of debt capital is supplied to
businesses by the direct purchase of debt instruments in capital markets
(estimated using the flow of funds accounts). Banks don’t supply much long-term
debt to businesses. Since debt is about 1/3 of overall capital and the rest
is equity, banks supply about 0.4 x 0.33 = 13.2 percent of all capital to
businesses. These are rough figures, but refinements won’t change the
overall conclusion. Even if Brown’s nirvana of socializing or
nationalizing banks were brought into being, it wouldn’t touch the vast
majority of capital that is directly supplied to companies.
I will now argue that her 40 percent figure is
vastly overstated. To do that, we will take an excursion through the basic
finance of which Brown is apparently ignorant.
What is capital? Capital consists of all goods that
people intend to use for activities that are intended to satisfy future
wants, as opposed to consumer’s goods that are used to satisfy
immediate wants. Capital is measured in terms of a money unit of account.
Businesses that produce goods for future consumption
use capital in their processes of production. This capital is scarce, which
means it is definitely not free or costless. There is competition to obtain
capital. There are markets for it called capital markets. There is supply of
capital and there is demand, and their activity produces a cost of capital
that is positive or above zero. If the price or cost of capital were zero,
the demand for it would vastly exceed the supply.
All capital has a cost, which is in fact called the
"cost of capital". This cost doesn’t vanish if a business
owner supplies his own capital to his own business. A person who uses his own
capital in his business loses the opportunity of supplying it to others at
the market price. He loses income that he could have gotten by allowing
others to use his capital. This person has an opportunity cost of capital. If
he makes a rational calculation and accounting, he should demand of his
business that it pay back to him this implicit cost of capital that he has
diverted away from an external market and used instead for his own business
purposes. What he has given up by not placing his capital in an external
market he should at least recover by using it for his own purposes. He
should, in essence, pay himself for the use of his own capital.
The cost of capital doesn’t vanish if a
government takes capital from its citizens and uses it for government
activities or government-owned businesses. If we think of the government as a
kind of organization owned by citizens, then, in the employment of capital by
the government, the citizens are analogous to a business owner that employs
his own capital in his business. That is, there is still a cost of capital
used by the government when citizens supply their capital or are forced to
supply it to the government. They lose the opportunity of deploying this
capital elsewhere in productive enterprises, and that loss measures the cost
to them of government’s absorption of the capital.
In other words, no magical gain occurs when
government absorbs and deploys the capital that it extracts from citizens.
The basic reason that no gain occurs is that capital is scarce, which means
it has a cost. That cost doesn’t vanish as capital is shifted from one
owner to another, including government ownership.
Brown fails to recognize this basic fact. She wrongly
thinks that if government keeps the interest that it gets its projects at
half price. All that happens, however, is that government recovers the cost
of capital for itself. The projects don’t cost any less at all. Her
error is like thinking that a man who uses his own $3,000 to build a
motorcycle can build it at half the cost of someone who borrows the $3,000
from a bank to build it. Obviously the costs of the materials, labor, and so
on are the same. The cost of the capital is less obviously present. With bank
borrowing, the man pays interest. Let us suppose that it’s at 6 percent
for one year, so he pays $180. The man who uses his own $3,000 loses the
opportunity to invest his funds externally. If he can invest at 6 percent, he
loses $180. This is a real cost to him of using his own funds. There is a
finance cost regardless of whether the bank funds the project or the man
funds the project himself.
All users or demanders of capital bear the cost of
capital. They pay it to capital suppliers to induce them to save, that is, to
forego consuming their resources and instead to invest them. The cost of
capital also includes payment for the risks that savers bear when they
transfer their capital to the users of capital.
Next, I expose the absurdity of her 40 percent
number.
How large are capital costs? A significant company
might have 1/3 debt and 2/3 equity capital. The cost of debt might be 6
percent. The cost of equity might be 9 percent. The weighted average cost,
excluding tax effects, is then 8 percent (1/3 x 6 + 2/3 x 9). These numbers
are made up, but they give a reasonable idea of overall capital cost. I will
use that 8 percent figure below.
A company employs capital and it has a balance sheet.
On one side, the left hand side, are the assets employed in the business. The
left side provides measures in money terms of the assets that the business
managers have decided to employ in the business in their production
processes, such as buildings, a cash account, inventories, vehicles,
computers, etc. The left side assets are capital in forms thought to be
productive. On the other side of the balance sheet, the right hand side, are
the liabilities (debts) and equity (or ownership) capital that finance the
business. It shows capital in the form that capital-suppliers have agreed to
make available to the business. The balance sheet always balances. The money
valuation of the left side assets equals the money valuation of the right
side liabilities and equity capital. We may use either total to measure the
total capital deployed in the business.
We see that the total capital employed in the
business is measured in book value (accounting) terms by either all the
assets on the one side or all the capital (debts + equity) on the other.
Let’s do a hypothetical example in which we
use the cost of capital as 8 percent. Suppose the company has $100 of assets.
Then it has $100 of capital in the business. These assets have to earn $8 in
order to cover capital costs of one year. Suppose that the business has sales
revenues of $150 during the year. The revenue is not business profit. Much of
this revenue will be absorbed by operating costs, such as payments for labor
services, payments for energy, payments for goods purchased from other
companies, payments for transportation, payments for advertising, payments
for distributions, etc. One of the costs is the cost of capital. On income
statements that calculate business profits, the costs of debt are explicitly
accounted for by interest costs. The costs of equity capital are not
explicitly accounted for, but they are still real. It is a mistake to
overlook them.
Business managers attempt to lower their costs so as
to produce greater profits. They will attempt to obtain capital to finance
the business at the lowest cost they can, all else equal. They might
conceivably measure their capital cost as a fraction of their sales revenues.
This ratio is not one that is ordinarily calculated in doing a financial
analysis. This is the ratio that Ellen Brown cites and relies upon as being
about 40 to 50 percent.
In our example, the ratio is $8/$150 = 5.33 percent.
The estimate of 40-50 percent intuitively seems way too high, and it is way
too high. It means that on a complete income statement of this company the
capital costs are $60 to $75. Suppose we use the 40 percent number or $60 of
capital costs. Suppose that debt costs are 6 percent. With debt as 1/3 of
capital, that means that debt costs are 0.06 x $33.33 = $2. That leaves $58
for the equity costs. The equity costs are $58/$66.67 = 87 percent. This is
outlandishly high. It is caused by Brown’s outlandishly high estimate
of 40 percent capital costs. Actual equity costs in the real world are
nowhere near 87 percent. They range from 8 to 15 percent for many established
corporations. They run higher than that for more risky enterprises, perhaps
15 to 25 percent. They don’t run 87 percent for businesses with
reasonable prospects..
What would be more reasonable? In my example, if $8
are capital costs and if $2 of this is for debt, then the remaining $6 is for
equity. The equity cost is then $6/$66.67 = 9 percent. That is more
reasonable. Very long run returns on common stock equity are near this
number. Long run returns on the accounting value of equity may run somewhat
higher, more like 10-12 percent. That still comes nowhere close to a number
that justifies the assertion that capital costs are 40-50 percent of the
selling price of goods, and that is what Ellen Brown asserts:
"According to Margrit
Kennedy, a German researcher who has studied this issue extensively, interest
now composes 40% of the cost of everything we buy. We don’t see it on
the sales slips, but interest is exacted at every stage of production.
Suppliers need to take out loans to pay for labor and materials, before they
have a product to sell."
Brown’s bottom line proposal is that the government create money instead of the banking system. She
wants the government to set up its own banks. She says that this would bypass
"the interest tab". We have seen that this doesn’t bypass the
cost of capital at all, not when that capital comprises real resources and
the government absorbs these resources. But Brown has another fallacy in mind
which is that fiat currency will eliminate the capital cost. She wants the
government banks to issue fiat currency which is non-interest bearing and in
this way fund projects at what she thinks is a zero capital cost.
Picture a government printing press for currency.
Citizens are required to accept the newly-printed paper in payments for
goods. Obama’s lieutenants take the paper currency and spend it for
their favorite projects. All this amounts to is a different kind of taxation
scheme by which the government absorbs (seizes) resources that are in limited
supply. The opportunity costs of these seized resources still do not vanish
no matter whether the resources are seized directly, taxed through the IRS,
or obtained by spending new pieces of green paper.
Brown is committing the same fallacy as the
Communists who attempted in vain to get rid of interest. It is an impossibility. The interest measures the postponement
of consumption and arises because of it. If there are to be any production processes,
they require capital and non-consumption. There will have to be interest. If
interest is forcibly suppressed, capital will flee and people will engage in
greater consumption. Capital will be consumed and the economy will go
downhill. Government printing presses amount to taxes on capital. They will
have the same results.
There is much that is wrong with our monetary
system. There are a good many critics of it who are offering sound criticisms
and sound recommendations for improving it. Ellen Brown is not among them.
Michael S. Rozeff
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