Re: Yes, the Earth is Round (1)

[Shann Turnbull <sturnbull@mba1963.hbs.edu>]

David Ellerman assures us that he and economists generally understand the
"productivity of capital".  However, there are some high profile economists
who use the word capital in ways which can be confusing and so unhelpful
for rigorous analysis.  It also becomes unhelpful for our discussion. 

For instance, Samuelson, (Economics, 8th edition, McGraw-Hill, 1970) states
" It should be pointed out that the government does own a good deal of the
national real capital, eg., Hoover Dam and submarines.  In addition, its
agencies such as the Federal Housing Administration (FHA) and the Small
Business Administration (SBA) are important sources of capital loans for
home-owners and private business".  As discussed on page 13 of my "New
Strategies" paper in the COG library, submarines are not used to produce
income and their manufacture absorbs income.  

Another instance is provided by economists, Shleifer & Vishny from the
National Bureau of Economic Research who in their 1996 Corporate Governance
Survey for the NBER used the word capital in four different ways to
indicate: (i) the means of production (p.6); (ii) an investment which may
not be represented by the means of production (p.3); (iii) finance (p.2)
and 'external capital' (p.6); or even  (iv) just credit created by
contract; ('bank debt' and 'junk bonds').  The problem introduced by such
ambiguity is illustrated by their reference to 'the people who sink the
capital' (p.3).  It is not clear if these 'people' are: (i) investors
subscribing for new shares; (ii) shareholders who purchase existing shares
from others; (iii) bankers who lend money; or (iv) the
managers/'entrepreneurs' who purchase the means of production or what
Moulton (1935:7) describes as 'procreative assets'.  The agency costs,
benefits and risk, change according to the various meanings of the word
capital as considered in my 1997 survey of corporate governance published
in Corporate Governance: An international review, 5:4, pp. 185-205.

Words are the tools of thinking. Words communicate concepts.  If we use
ambiguous words then both our communications and analysis will be subject
to ambiguities.  Rigorous analysis requires rigorous words.  The word
"capital" does not meet this test even when qualified with terms such as
"real", "financial", "equity", "external", "shareholders", "foreign",
"loan" etc. etc. Some sorts of real assets like submarines do not earn
income.  Some "produced means of production" or "real capital" may or may
not become income producing.  However, even when such assets produce an
income it may or may not produce sufficient income over its operating life
to recover its set up and operating costs.  Income producing assets which
generate cashflows in excess of their set up and operating costs become
"self-financing" and produce surplus cashflows.  

However, the word "capital" or the phrase "income producing assets" does
not distinguish between "produced means of production" (or "productive
assets") which are self-financing and those which are not.  So when people
use the words "real capital", "produced means of production", "income
producing assets" they may or may not be referring to self-financing
assets.  Without this knowledge it is not possible to undertake a complete
analysis of the situation.  

It is only self-financing assets than can produce surplus cashflows and it
is only by producing surplus cashflows that the standard of living can
increase without people working harder or longer.  To avoid ambiguity in
communication and ambiguous or woolly analysis we need a special word to
identify when we are discussing those special types of "real capital",
"produced means of production", or "income producing assets"  which can
alone generate economic growth without people working harder or longer.  This
is why and when I adopt the word "procreative" as used by Harold G. Moulton
 in his 1935 book "The formation of capital".

Assets which do not pay for themselves absorb income and so I coined the
term "degenerate" asset.  In my 1975 book, Democratising the Wealth of
Nations I also coined the word "consumption asset" to describe degenerate
assets which have use value (consumer durables autos, white goods,etc.) and
so reflect the standard of living rather than being the means for
increasing it.

The word and concept of procreative assets provides a powerful, if not an
essential intellectual tool, for understanding economic development and for
designing development institutions and policies for self-financing economic
development as discussed in my posting of October 21 discussing the
contribution of Charles Upton.  The above explanation should also assist in
showing the significance of the word as used in my opionion article
included in my October 21 posting.  It should also help to answer the
question raised at the end of my posting of October 19th to the Homestead
Group on Corporate Ownership and Control as to how to communicate the
problem of surplus profits which can emerge as part of the surplus
cashflows of procreative assets. 

Without the word and concept of "procreative assets" I do not believe that
the World Bank, other development institutions or policy advisors have
sufficiently unambigous intellectual tools to be as effective as they could be.

I shall respond to the other points raised by David below with another
posting as they involve other subjects.  Those discussion will however
depend upon identifying "self-financing" or procreative assets.

Cheers

Shann

At 12:17 AM 20/10/1999 , you wrote:
>

>This is in response to several EMs, one from Michael Harrington on 8/10 and a
>brief one on 10/14, and to an intervening one from Shann Turnbull on10/13.
>
>1. I am abit puzzled by the continuing criticism of orthodox economics that 
>they
>don't understand the "productivity of capital"!  This is one of the kooky
>aspects of Kelsoian economics--the idea that capitalist economists don't know
>about the productivity of capital because of the journalistic emphasis on the
>statistic of "labor productivity" which is sometimes shortened to
>"productivity".  Please crack any text and read about capital theory.  I am 
>just
>baffled how anyone could really think capitalist economists have fallen
down on
>their job to emphasize the productivity of capital.
>
>Perhaps the logic is like this.  Kelsoians discover that the earth is
round and
>then after some bizarre reasoning conclude that the moon is made of green
>cheese.  When others deny that the moon is made of green cheese, the
Kelsonians
>accuse them of not realizing that the earth is round.  Let me assure all
>Kelsonians within earshot that conventional economists really do understand 
>that
>capital is productive.  The disagreement must lie somewhere else!
>
>Anyway on to substantive issues.
>
>2. One of the issues about ESOPs is who ends up paying for ESOP shares?  MH
>dodged the issue by modeling it as a case of borrowing money to buy equity and
>then paying off the loan with the proceeds from the equity.  MH is trying to
>model the ESOP on the limiting case of a 100% leveraged buyout where the ESOP
>trust, in effect, plays the role of the acquisition shell.  But ESOPs work for
>any percent of ownership, and the general result I referred to is that without
>any productivity effect on workers or changing wage demands and things of that
>sort, then the value of the shares that end up in the workers hands comes from
>dilution and tax breaks. In the near 100% or 100% buyout case, there are no
>other shareholders to dilute so the LBO enterprises often ended up having to
>partially decapitalized to make the payments for the loans that financed the
>LBOs (remember the 80s?)--sort of a self-dilution.  Alot of the hoopla in the
>80s was about all the productivity improvements that the new management was
>going to make to be able to pay off the loans without decapitalizing the
>companies.  I will submit my paper on "Who Pays for ESOP Shares?" to the
>discussion list.  It gives a derivation of these results.
>
>In general, ESOP loans are hardly paid for out of dividends (as I pointed
out).
>If they were, then indeed it would be a trivial transaction to analyze, namely
>borrowing to buy equity and paying the debt off strictly from that equity.
>
>To better see the problem, perhaps one should focus on the shell game involved
>in the two descriptions of the ESOP transaction.
>
>ESOP descriptions often involve a type of "shell game" of switching
between two
>quite different interpretations of the transaction.  The front-end is
described
>as an equity injection?a purchase of shares at full market value.  And the
>back-end of the transaction is described as paying off a loan with pretax
>dollars.   But if the front-end is described as shares being purchased with
>money borrowed by another party (the ESOP), then it should be added that the
>corporation itself pays off the other party's loan with the ESOP contributions
>[the corporation and ESOP can only be identified in the 100% case].  And
if the
>back-end of the transaction is described by paying off a loan with pretax
>dollars, then it should be added that the company has already "paid for" the
>cash injection (the loan) with the transfer of shares to the ESOP.   But ESOP
>descriptions often focus on either the front-end equity injection or the
>back-end tax-favored loan payments without giving the effect of the whole
>transaction.
>
>In fact, the company pays twice for the money it receives in an ESOP loan,
once
>with the new shares issued to the ESOP (a quid pro quo transaction) and the
>second time with the loan payback.  The tax break on the loan payback reduces
>the 100% dilution of the second time the funds are paid for to whatever is
left
>after the tax break.  If the company is in a 40% bracket, then 40% of the ESOP
>shares value is paid by the tax break and the remaining 60% is dilution.  This
>is all shown rigorously in the aforementioned paper.
>
>If the ESOP loan buys say 10% of the shares, then the company (which is 90%
>different from the workers) is paying off the loan which means less value to 
>the
>equity (90% owned by others) and that is dilution.  But the company gets the 
>tax
>break to pay off the loan that way, so the dilution is less than it would
>otherwise be due to the tax break.  One has to carry through this analysis to
>see why the stuff about "self-liquidating loans" was intellectual fog to cover
>up the dilution.
>
>MH's attempt to use CAPM-style arguments is a non-starter since one can go
>through the whole analysis of dilution & tax breaks under conditions of
>certainty (so clearly the risk premium on equity is not the essence of the
>argument).  Suppose a model has characteristics A and B, with A presented as 
>the
>cause of B.  But then one takes another model without A and finds that B is
>still there, so A (worker risk-bearing) was apparently not the cause of B 
>(value
>of shares ending up in worker hands).
>
>Naturally one should also be cautious about attributing the CAPM risk 
>premium to
>some special productivity of capital since it derives from the assumed
>risk-averse nature of the economic agents, not from a characteristic of the
>capital goods or financial capital.
>
>
>Let me move on now to Shann's EM of 10/14.  He starts off with saying that
>according to his interpretation of my Chapter 6, I don't understand "that
>productive assets provide a source of greater productivity, income and
growth."
>Many thanks, Shann, for pointing that out.  I guess I must have missed that.
>[You see Vic, I am learning already from this debate so it isn't totally
>stupid.]
>
>Shann goes on to say that the dilution argument is possible only because
>"bankers" don't enforce "ownership sharing" where the latter I think means
>Shann's form of expiring (dynamic) property rights in capital (like the 
>expiring
>property rights in intellectual capital).  Perhaps this would be a good 
>place to
>comment on that idea.  There already are examples of essentially such property
>rights, namely ownership of rental properties in rent-controlled districts.
>With no de facto or de jure subletting, then the people living in those
>apartments are in effect getting part of the rental (being allowed to not 
>pay it
>to the property owner) so the rental control has the (well-known) effect of
>attenuating the property right.  This does not model the time-change in
Shann's
>expiring equity rights but it does model the attenuation and that is the
source
>of the problems.  There is firstly a problem with the switchover.  The
owner of
>the property might have bought it for full price so the imposition of the
>attenuated-right scheme amounts to a partial expropriation which may cause a
>political problem to more people than "bankers."  Secondly, there are 
>well-known
>supply effects.  Given a choice, no one would build rental properties in
rental
>controlled areas.  Or to be more precise, if the rent controls took away say
>half the return, then one would only build super profitable properties so that
>the attenuated rate of return to invested capital would be normal.  Thus the
>effect of this suggestion would be to cut down on the production of the
capital
>to which the attenuated property rights apply, a funny suggestion from one who
>is accusing others of not appreciating the productivity of capital.
>
>Anyway, moving on, Shann goes on to say that the chapter shows that "Ellerman
>believes that economic development is created by the productivity of labor
>rather than the productivity of productive assets..."  In other words,
Ellerman
>must not realize that the earth is round since he does not buy our conclusions
>that the moon is made of green cheese.
>
>The next few paragraphs talk about Harold Moulton's notion of "procreative
>assets" which are "a special class of productive assets which over their
useful
>life create more value than the cost of their establishment and operations
>before the transfer of any value in the form of interest payments and taxes.
>That is, all procreative assets must by definition become self-financing.  It
>would seem that modern economists no longer use the concept of procreative
>assets and so have lost an intellectual tool to ..."  Shann, you really
have to
>take a peek at any economics or corporate finance text.  That is simply the
>ordinary notion of a capital asset which might yield a profit after the
>subtraction of all costs of acquisition and operation.  That is perfectly
>ordinary capital theory in Samuelson's or any other text.  How could you
>possibly think that is some sort of discovery??
>
>I don't think I will be long for this debate if I am called upon to explain 
>that
>capitalist economists really do understand the notion of capital goods
that are
>profitable to buy and operate.  If that is supposed to be the discovery that
>Kelsoians have made, then I think we have a clue why economists don't take
>Kelsoians seriously.  Actually, Kelso discovered something much more important
>which I spelled out in the chapter but which could be rephrased as a way to
>dilute absentee shareholders in favor of workers all under a verbal
smokescreen
>about the wonders of "capital."  Now that really is an accomplishment!
>
>The dilution + tax break argument is still the starting point to
understand the
>key point of who pays for ESOP shares, and, so far, the commentators have not
>engaged the argument.  Ranting that others don't appreciate one's discovery of
>the round earth will not do.
>
>Instead of wasting your and our time with such a banality from Moulton, the
>first president of the Brookings Institution, why don't you read Brookings
>himself?  He suggested
>
>
>     to  require  that  [interstate]  corporations  should reincorporate 
>under a
>     federal  incorporation  act;  which  act,  while securing to capital a 
>fair
>     return  at  a  fixed rate of interest and dividends, risk considered, 
>would
>     divide  all  additional  profit  or  accretions in the form of labor 
>shares
>     between  the  employees  (management  and  labor)  in  the  ratio  of 
>their
>     individual  contribution,  probably  as  recorded  by  their wage or 
>salary
>     compensation.  [Brookings,  Robert  S.  1932,   The Way Forward.  New 
>York:
>     MacMillan, 17-18]
>
>
>     This  reform  would consist largely in the rental of capital by the 
>workers
>     and  management,  stabilizing a fair rental return for it while leaving 
>the
>     workers  and  management  as their remuneration all the profits. 
>[Brookings
>     1932,  The Way Forward.  New York: MacMillan, 73-74]
>
>
>
>
>
>_______________________________
>David Ellerman
>Economic Advisor to the Chief Economist
>World Bank, Room MC4-335
>1818 H St., NW
>Washington, DC 20433
>Ph: 202-473-6368
>Fx: 202-522-1158
>
>

Shann Turnbull
P.O. Box 266 Woollahra, Sydney, Australia, 1350
Phone: 02 9328 7466 office; 02 9327 8487 home
Fax: 02 9327 1497 home & office.  Mobile 0418 222 378
Outside Australia, replace first "0" with "61" after international access code
Life long E-mail: sturnbull@mba1963.hbs.edu
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