THE INTELLECTUAL VOICE OF CAPITALISM ON THE INTERNET
The Jefferson School of Philosophy, Economics, and Psychology

Literature and Lectures by Edith Packer, George Reisman, and Others

Reisman's Blog

Reisman's Essays and News Commentaries

Library of Liberty

Home

The Stock Market, Profits, and Credit Expansion^*

By

George Reisman^**

1. The Plunge in the Stock Market

The plunge in the stock market has resulted in the wiping out of pension funds and many people’s life’s savings. It has also been accompanied and reinforced by the allegation of accounting scandals at several major firms, in which key executives were apparently able to reap substantial personal gains despite the destruction of the firms that employed them and the losses of their fellow shareholders. 

The combination is operating like the collapse of a dam, unleashing a torrent not of water but of hatred—hatred of capitalism and its most visible and valuable representatives: big businessmen. They and their “greed” for profit are depicted as the cause of the collapse. No less a personage than Alan Greenspan, Chairman of the Federal Reserve Board and for many years allegedly a staunch defender of capitalism, has attributed the collapse to “infectious greed.” A jeering mob of media-types, armed with microphones and other appurtenances of modern technology, instead of knitting needles, is as ready to see businessmen brought down as any mob of the French Revolution was to see the hated aristocrats go to the guillotine.

What is happening must be understood against the background of profound ignorance that exists on the part of today’s intellectuals concerning the nature and functioning of capitalism and the profit motive. Despite the worldwide collapse of socialism and the undeniable, visible success of capitalism, the intellectual world for the most part remains as predisposed to socialism and opposed to capitalism as ever.

The great majority of today’s intellectuals--from newspaper and television commentators to university professors, including most professors of economics, not to mention today’s politicians and government officials--regard the failure of socialism and success of capitalism as mere “brute facts,” that is, facts without intelligible basis; indeed, facts defying and contradicting all understanding. To know otherwise, they would have had to read and study the works of Ludwig von Mises and the other leading theorists of the Austrian and British classical school of economics. But this they have not done.

As a result of this fundamental intellectual and moral failure on their part, according to all that they still believe, socialism, with its alleged concern for the well-being of all and its alleged rational planning, should have succeeded, and capitalism, with its concern only for personal profit and its alleged anarchy of production, should have failed. In the minds of today’s intellectuals, the opposite outcome in the real world, must call into doubt the reliability of reason itself—a result, I believe, that goes a long way in explaining the rise in openly professed irrationalism in recent decades, such as the assaults on science and technology emanating from the environmental movement. The intellectuals seize upon today’s events in connection with the stock market because they appear to offer a reprieve from the overthrow of their intellectual universe. They believe, for the moment, that they are once again in a position to say that their view of capitalism is confirmed by reality.

The major directly relevant aspects of the intellectuals’ ignorance must be countered, with a scientific explanation of the actual nature and consequences of the profit motive in a free market, followed by an explanation of how profits are profoundly distorted by forcible government interference in the form of inflation and credit expansion, in ways that directly explain both the stock-market boom of recent years and today’s stock-market bust. In the light of this knowledge, current proposals allegedly aimed at remedying the present situation and preventing its recurrence--but in fact aimed at the further undermining of capitalism--must be exposed and criticized.

2. The Profit Motive as the Foundation of Economic Improvement

What the intellectuals’ hostility to profits and the profit motive ignores is that the quest for profit in a free market is the source of virtually all economic improvement.

In a free market, what one is free of or from is physical force, including  fraud. Since this principle applies to everyone, one is at the same time oneself prohibited from taking the property of others against their will, which includes taking it by  dishonest means. Anything one receives from others must be by their voluntary choice.[1]

In a free market, the way one obtains money from others is by offering them something they judge to be valuable and desire to have. These are the kinds of things one seeks to produce and sell. In this way, the profit motive is the foundation of the continuous introduction of new and improved products and methods of production. The development of new and improved products that people will want to buy, and the more efficient, lower-cost production of what they already want to buy, are the leading ways in which businessmen make profits in a free market.[2]

No less ignored by today’s intellectuals is the fact that the overwhelming bulk of profits in a free economy is saved and reinvested, and that the accumulation of any great fortune in a free economy is the result of introducing a whole series of improvements and using the far greater part of the resulting profits to create the means of delivering those improvements to the general public.

Thus, as a classic example, Henry Ford, who started with a capital of about $25,000 in 1903 and finished with a capital of about $1 billion at the time of his death in 1946, was responsible for a major part of the tremendous improvements made in the kinds of automobiles produced over that period and in the efficiency with which they were produced. It was largely thanks to him that the automobiles of 1946 were so far superior to those of 1903 and had declined in real cost from a point comparable to that of a yacht to a point where practically everyone could afford an automobile. At the same time, Ford’s growing fortune was invested precisely in the growing production of such improved automobiles. In other words, the other side of the coin of Ford’s growing fortune was the general public’s growing benefit.

A more recent and equally obvious example of the same principle is the case of Intel. In the early 1980s, Intel was in the forefront of producing what was then the most advanced chip for use in personal computers: the 8086. Competition did not allow the high profits it made from that chip to last very long, however. To continue earning a high rate of profit in the computer-chip industry, it was necessary for Intel to introduce the greatly improved 80286 chip. And then the same story repeated itself, and to continue earning a high rate of profit in the face of the competition always nipping at its heels, Intel had to develop and introduce the 80386, then the 80486, and then successive generations of the so-called Pentium chip. Intel has made a fortune in the process. Its fortune is invested precisely in the production of today’s radically improved computer chips that are produced at a small fraction of the cost of the chips of a decade or two ago. (Of course, the profits earned from any given improvement can often be invested in expanding the production of other, totally different products as well.)

These examples are not isolated. The principle they illustrate operates universally, to the extent that the market is free. Its greatest illustration can be seen in the whole rise in the standard of living that has taken place over the last 100 years. In 1902, the average worker worked about 60 hours a week. What he received in return was the average standard of living of 1902—a standard of living that did not include such goods as automobiles, air conditioners, air travel, antibiotics, refrigerators, freezers, motion pictures, television sets, VCRs, DVD players, radios, phonographs, CD players, or personal computers. Telephones and electric light and power were uncommon. Electric appliances were virtually unheard of. Cell phones, of course, were entirely non-existent.

The goods that could be produced, such as various kinds of food, clothing, and shelter, were all far more expensive in real terms than they are today, that is, in terms of the time needed to earn the money required to buy them. The diet, wardrobe, and housing of the average person was far more modest then than now. These goods became more affordable and improved in quality and variety only as the quest for profits led to the necessary cost-cutting and other improvements in their production. And all of the goods that did not exist at all in 1902 came into existence only because of the quest for profits.

In other words, what so radically improved the standard of living of everyone was nothing other than the existence of the profit motive and the freedom to act on it as the guiding principle of production and economic activity. Everywhere, in every industry, in every town and city, there were men eager to profit by improving products and methods of production. They were free to do so and they succeeded. This “greed,” “infectious” to the point of being all-pervasive, is what so radically improved the standard of living of the average person. It is something we should all be profoundly grateful for. To whatever extent it would have been less “infectious” and less pervasive, the improvement in the standard of living would have been less.

The extent of the improvement for the average person can be gauged from the fact that his standard of living of today can be taken as at least 10 times that of 1902, and it is obtained by performing on average only two-thirds as much labor—40 hours of labor per week instead of 60. Thus, two-thirds the labor of 1902 now earns the money sufficient to buy ten times the goods! A mere tenth of that two-thirds, or 6 2/3rds percent, is today sufficient to buy goods equivalent to the average standard of living of 1902. This means that on average, thanks to the greed of businessmen and capitalists, there has been a fall in real prices since 1902 on the order of 93 1/3 percent!

3. Inflation, Or Why Prices Keep Rising Despite the Profit Motive

Of course, outside of the field of computers and their peripherals, and a few other goods, such as VCRs and pocket calculators, there is very little obvious evidence of the fall in prices. While real prices have fallen dramatically, prices expressed in paper money have for the most part risen just as dramatically or even far more dramatically. This is because prices today are expressed in terms of irredeemable paper money. No natural scarcity limits the supply of such paper money, and it is virtually costless to produce. If its production were open to free competition, it would quickly become worth no more than paper clips, pins, or small metal staples, which are goods with a comparably minimal cost of production. The prices of all of the more significant goods expressed in terms of it would be in the many millions at least, just as the number of paper clips et al. at a penny or less each needed to equal the price of a new automobile, say, is already in the millions. Indeed, irredeemable paper money would become valueless altogether, because the same free market that permitted free competition in its production would offer the alternative of far superior monetary media, notably gold and silver, which would proceed to takes its place as money and utterly eliminate any demand for it.

What prevents the immediate total destruction of the value of irredeemable paper money is that its issuance is a monopoly privilege of the government. This makes possible a slower, more protracted decline in its value, though one which is still substantial and is inexorable. So long as irredeemable paper money retains any of its value, the government that issues it is in the position of having a still valuable item to offer which it can obtain at virtually no cost. A vast array of pressure groups want money from the government, and it can obtain their support by giving it to them. In other words, the government inflates the money supply in order to buy votes. This inflation of the money supply makes the value of the monetary unit decline. Prices rise despite the great success of businessmen in making goods ever more abundant and less expensive in real terms, because paper money becomes more abundant and cheaper at an even faster rate.  

4. The Effect of Inflation and Credit Expansion on Profits

The government’s inflation of the money supply has a major bearing on profits as well as on prices, and--by means of these two connections--on the stock market, as I will show. In the very nature of the case, an expansion of the money supply operates to raise profits. Profits, are the difference between sales revenues and costs. The expenditures that constitute the costs are usually made in advance of the receipt of the sales revenues, sometimes even decades before. Such is the case of expenditures to construct buildings, which are depreciated over forty years or more, which means that the expenditures to construct them show up as costs over a forty year period, typically, one- fortieth per year. To the extent that the quantity of money and thus the volume of spending in the economic system increases over time, the sales revenues of later periods tend to exceed the relevant outlays made in earlier periods for factors of production, by a correspondingly wider margin, which, of course, means that profits are increased.

The rise in profits caused by an increase in the money supply would exist to a modest extent even under the purest gold standard, insofar as the quantity of gold money and thus spending in terms of gold increased over time. Under an irredeemable paper money, with nothing to limit the rate of increase in the quantity of money, it is obviously far greater.[3]

The rise in profits is still further increased to the extent that the banking system, operating with the government’s sanction, and under its protective umbrella, enters into the process of money creation and engages in credit expansion—i.e., the granting of loans out of newly created money. As Ludwig von Mises has shown, credit expansion creates the appearance of a larger supply of capital and serves to reduce the market rate of interest below what it would otherwise be.[4]

To the extent that this results in the undertaking of longer processes of production, and insofar as this means that processes of production are undertaken in which the outlays for factors of production take a longer time before they show up as items of current cost, there is necessarily a further rise in profits. This is because while such  production expenditures make the same contribution to sales revenues in the economic system—i.e., they constitute the sales revenues of the sellers of capital goods and, insofar as they constitute wage payments, they enable the wage earners to make expenditures for consumers’ goods—their appearance in business income statements as items of current cost is more or less significantly deferred to future periods, with the result that the magnitude of costs appearing in the income statements of the present period is reduced and profits in the economic system are correspondingly increased.[5]

The recent accounting scandal at Worldcom can perhaps help to illustrate the principle that is present. Worldcom allegedly reported almost $4 billion of additional profits by virtue of wrongly classifying expenditures of that amount for routine maintenance, which should have appeared as an item of current cost in the very same accounting periods in which the expenditures were made, as items comparable to the purchase of durable assets, whose value shows up as current costs only in future accounting periods. Had Worldcom, without ill effect on its operations, been able to reduce its expenditures for routine maintenance by $4 billion and actually used those funds for the purchase of durable assets, its profits really would have been increased by $4 billion. For it then would still have had the same sales revenues it had, but legitimately $4 billion less of current costs.

To bring about comparable effects on profits in the economic system as a whole, it is not necessary for credit expansion to achieve a reduction in the total current costs recorded in any given year in the economic system in comparison with the year before. Credit expansion causes an increase in profits to the extent that it represents a concentration of the new and additional production expenditures taking place over a period of years on factors of production whose acquisition values show up as items of current cost only with more or less considerable delay. This will certainly be the case to the extent that the funds made available by credit expansion are used to finance equipment purchases and the construction of factories and office buildings. The result of this is that while the increase in the quantity of money and volume of spending that credit expansion entails brings about a certain rise in production expenditures and sales revenues, the tilt of the production expenditures to showing up as costs further in the future, serves to retard the rise in current costs and to correspondingly enlarge the increase in profits in the economic system.

It should be realized that any given amount of credit expansion is capable of increasing production expenditures and sales revenues many times over. For example, it is possible that credit expansion in the amount of $100 billion could increase production expenditures and sales revenues by $1 trillion or more and, conceivably, also increase profits by $1 trillion. This would be the case, however unlikely, if the entire $100 billion of sales revenues initially generated by the credit expansion were entirely saved and then reexpended as a second $100 billion of production expenditures. This second $100 billion of production expenditures would generate a second $100 billion of sales revenues. If the same story were repeated eight more times within the same year, the total of an additional $1 trillion of production expenditures and sales revenues would be reached. A full trillion dollars of additional profit in the economic system would result if the entire amount of additional production expenditures were of a kind that would not show up as current cost until after the end of the current year.[6]

An increase in profits also takes place to the extent that credit expansion causes additional consumption expenditure over and above that of wage earners made possible by additional production expenditure. Credit expansion causes an increase in such consumption expenditure both directly and indirectly. It does so directly insofar as it makes possible the granting of additional home-mortgage loans and additional consumer-installment credit. These enlarge the demand for such things as new homes, home furnishings, major appliances, and automobiles, and correspondingly increase the sales revenues and profits of the sellers of these goods. Credit expansion indirectly increases such consumption expenditure to the extent that the higher profits and, especially, the rise in asset values that it generates, notably the rise in stock prices and real estate prices, provide a seeming basis for stepped up consumption spending. (The rise in stock prices will be discussed further, very shortly.)

Additional consumption spending is a source of additional profits perhaps to an even greater extent than is the tilt of production expenditures more to the future and the corresponding deferral of the appearance of current costs. Consumption expenditure, as John Stuart Mill pointed out more than a century and a half ago, is not a demand for labor (except to the extent that it literally constitutes a payment of wages, as in the case of a housewife’s employing a maid). Nor is it a demand for material factors of production. It is sales revenues to the sellers of consumers’ goods. And that is all.

Most of this additional sales revenue constitutes additional gross profit. Additional cost is present only to the extent that the additional consumer demand is met by selling additional goods out of inventory. To that extent, the additional consumer spending is accompanied by the incurrence of additional cost-of-goods sold. Additional cost may also be incurred to the extent that there is additional commission cost.[7] For the rest, the additional sales proceeds constitute additional profit. Additional demand for labor and material factors of production depends on the extent to which the sellers of the consumers’ goods save their sales revenues and profits and use them for the purpose of making additional production expenditures. And in that case, the extent to which there will be additional current cost, or when there will be additional current cost, depends on how long it will take for the production expenditures to show up as current costs.

To the extent that  instead of saving, the sellers themselves consume their additional sales revenues and profits, or pass them to stockholders by means of dividend payments or repurchases of outstanding stock, and the stockholders consume the proceeds, there is only further consumption expenditure and a further addition to sales revenues and profits elsewhere in the economic system. The same is true to the extent that the additional sales proceeds are seized by the government as taxes and then consumed by the government.

5. Credit Expansion and the Stock Market Boom

The boom in profits caused by credit expansion is accompanied by a corresponding and even more than corresponding boom in the prices of stocks, insofar as credit expansion provides new and additional money that enters the stock market. Newly created money that is lent to corporations to buy back some of their own shares, a common practice in the last boom period, or to engage in mergers or acquisitions through the purchase of shares in other firms, places funds in the hands of the sellers of those shares. They in turn use the money they receive, or at least the far greater part it, to buy shares in other firms. The sellers of those shares, in their turn, buy the shares of still other firms. Thus, the new and additional money that enters the stock market travels from one stock or set of stocks to another as a new and additional demand, raising stock prices in the process. And once underway for a while, the rise in stock prices is further fueled by the attraction of funds from all kinds of investors eager to cash in on the prospect of continually rising stock prices. The rising profits of business are thus accompanied by stock prices at rising multiples of those rising profits.

As already indicated, the rise in stock prices is responsible for the share of profits that is consumed being artificially increased. In the absence of credit expansion and its effect on stock prices, increases in profits would be heavily saved and reinvested. A businessman with high profits in such conditions would think of himself as growing rich only to the extent that he used his profits to add to his capital, i.e., saved and reinvested them. But to the extent that the rise in stock prices outpaces the accumulation of capital in this way, businessmen think of themselves as already that much richer and able to afford to consume more without in fact first actually being that much richer. This is a major way in which credit expansion undermines saving and capital accumulation.

Fortunately, the boom in profits and in stock prices caused by credit expansion is not sustainable. If it were, the economic system would suffer in two major ways: the demand for consumers’ goods would be permanently increased relative to the demands for capital goods and labor. And the demands for capital goods and labor themselves would be permanently distorted in favor of capital goods and labor serving the more remote future at the expense of capital goods and labor serving the less remote future. The result of these developments would be a substantial undermining of capital accumulation, possibly to the point of bringing about economic retrogression. The rise in the productivity of labor and in real wages would thus also be undermined if not reversed.[8]

6. Why the Credit-Expansion Boom Cannot be Sustained

One reason why the credit-expansion boom is not sustainable is that many of the projects financed by credit expansion are doomed to suffer major or total financial loss. This outcome follows from the very nature of their financing, which to be understood requires that we first consider a market without credit expansion.

In a market without credit expansion, the source of all capital investment is saving and accumulated savings. Savings are typically difficult to accumulate because, first of all, the income out of which they are accumulated is difficult to earn. In the absence of credit expansion, money is not “easy” and it does not come easily. It has great and probably growing purchasing power (this assumes, of course, that inflation is not present in forms other than credit expansion, i.e., that the money is gold or silver). Every piece of money earned by virtue of the sale of goods or services to others must pass the test of those others having to value the goods or services one offers above the money they pay for them. The only other way that money can be honestly obtained in these circumstances is by laboriously digging it out of the ground, in mining operations.

Thus it all must be earned, and large sums especially come only with great difficulty or uncommonly great ingenuity. And once any money is earned, the temptation to consume it all must be overcome by definite acts of will. In this environment, investments are almost always made with careful deliberation and judiciously, for if there is a loss, something of great value will be experienced as having been lost.

There are always some men with great financial visions that they seriously believe in and do so strongly enough to try to bring them to fruition in reality. In the absence of credit expansion, the only funds available to them are their own and those of the small number of others who can be persuaded after due deliberation to share their vision and are willing to take the risk of loss. Typically, such ventures begin with small capital investments and only after demonstrating their success by being able to earn a substantial rate of profit on the initial investment is more capital forthcoming. And much or possibly even all of this additional capital, will consist of nothing other than the reinvestment of the profits themselves. The effect is that the capital invested in the business grows in line with, and on the foundation of, its already demonstrated success. Additional outside, borrowed capital is attracted only insofar as the growing capital of the original investors can provide a substantial buffer of safety for the creditors.

With credit expansion, matters are very different. Here huge sums become available overnight, out of thin air. These are sums that have not had to be saved and accumulated and whose loss will not be the loss of anything previously owned nor, therefore, be experienced as the loss of anything of any great personal value. Thus it is not surprising that the funds created by credit expansion are not invested with the same forethought and prudence as funds accumulated by saving. Nor should it be surprising that again and again they are invested in grandiose projects without any demonstration of previous profitability whatever. A record of proven profitability is no longer required when capital funds are created out of thin air and profit ceases to be a necessary source of capital.

Once underway, the rising profits created in the economic system by the process of credit expansion itself appears to justify further credit expansion. Practically everything becomes profitable or considerably more profitable. The rise in stock prices fueled by credit expansion creates capital gains left and right. Soon hordes of people appear to be rich, with more money available to invest than they had ever imagined, and in more profitable ways than they had ever known.

In the place of the serious visions of the few, that are initially financed on a shoestring and must prove themselves and finance their expansion by earning profits, come the pipe dreams of the many, launched with enormous sums. And as the new firms swarm into the latest investment fad—in one era, canal building; in another, railroad building; in a third, electric power-plant construction; in a fourth, radio; and, most recently, in our day, the “dot.coms” and the internet—a host of observers is always on hand, in all eras, to trumpet the arrival of  the “new era,” or the “new economy,” or the “new” something or other that allegedly explains why it has become all right to throw all rational principles of investing to the winds and to construct vast new facilities of a kind for which customers will not appear in sufficient numbers for another generation or more to make them profitable.

In the most recent bubble, after such pie-in-the-sky projections as that Internet traffic would double every hundred days were abandoned, it even became acceptable in some quarters to value stocks based on their multiple, not of profits, which did not exist, but of sales revenues. Many of the new “dot.coms” promulgated the concept of the “burn rate,” by which they meant nothing more than how long it would take them, while waiting for customers who never appeared, before their extravagant rates of expenditure exhausted the capital they had raised in their sales of stock to the public—a public many of whose members believed that they knew something about investing because gains had showered down upon them and they had meanwhile learned to utter such impressive-sounding terms as “large caps,” “small caps,” and “medium caps.”

This is the kind of investment (and investors) that credit expansion produces: Massive malinvestments and the sheer waste of immense sums of capital. Most of the dot.coms are now largely worthless. The massive investment in telecommunications in connection with the projected growth in the internet is now estimated to be worth between 3 and 10 cents on the dollar.

In addition to the losses sustained by the malinvestments financed by credit expansion, there is the fact that the additional profits based on a lengthening of processes of production cannot be sustained for very long in the absence of continued, and, indeed, accelerating credit expansion. Any stabilization in the extent to which production expenditures are devoted to years further in the future, must sooner or later eliminate the effect of the reduction in current costs, because the costs previously shifted to the future will become current as soon as that future arrives. And when they do become current, they will largely offset comparable deferrals of cost to the future at that point.

Thus, for example, even though outlays for equipment with a five-year life are going on instead of outlays for immediate expense, once there are five years of such outlays, annual depreciation cost will have risen to the same point as would have existed earlier for current cost on account of immediate expense items. And that depreciation cost will offset the effects of continuing production expenditures of a constant amount for equipment with a five-year life. At that point, the only extent to which there would be any lag in costs would be the extent to which production expenditures for assets of given lives tended to grow from year to year. The special effect on profits of a lengthening of processes of production would be over, unless somehow, they could be made to lengthen further.

A continual acceleration of credit expansion would make it possible both to go on  with the effect on profits of a lengthening of the processes of production and, if it were rapid enough, even to avoid the appearance of losses from malinvestments. However, such a policy would be one of hyperinflation and would soon destroy the monetary unit. To prevent this from happening, the government slows or stops the credit expansion.[9]

7. Why Profits and the Stock Market Plunge

The slowing or cessation of credit expansion and the concomitant tendency of production expenditure to return to a less future-oriented tilt, means an almost immediate plunge in profits throughout the economic system, as the growth in sales revenues declines or ceases altogether and current costs rise. Indeed, production expenditure may now go beyond returning to the disposition between present and future which it had prior to the credit expansion, and assume as much of a tilt toward showing up as current costs sooner as credit expansion had previously caused it to tilt toward showing up later. This will likely be the case in all those industries in which credit expansion has brought about an undue expansion of plant and equipment and in which firms will now make sharply reduced expenditures for plant and equipment.

A variety of factors operate to intensify the effects of this profit squeeze. One is the fact that the artificially low market rate of interest in the period of credit expansion has served to encourage the growth of business debt. (The rate of interest should be understood as having been low relative to the rate of profit, not as necessarily low in any absolute sense.) Another is the fact that credit expansion has served to encourage a reduction in the demand for money for holding. It has created an environment in which businessmen have been encouraged to substitute the prospect of borrowing readily and profitably for the actual holding of money. Thus many firms are now highly illiquid as well as being heavily indebted. A third, as we have seen, is that credit expansion has resulted in extensive malinvestments—investments of a kind that would not have been undertaken in the absence of credit expansion and whose unprofitablility is pronounced.

In this situation, the potential exists for a financial contraction, as businessmen strive to rebuild their liquidity by stepping up sales and cutting back purchases. Business failures are easily compounded. There are the failures of ventures revealed to be malinvestments. And then further failures can readily occur as the result of financial contraction and its accompanying decline in sales revenues and asset prices and thus in the ability to repay debts. Both sets of business failures create the potential for bank failures and thus for an actual decline in the quantity of money, as the deposits of failed banks are transformed overnight from money into junk securities.

As this environment develops, stock prices plunge. As they do, the prop supplied to consumption and profits by high stock prices falls away. Now the stock market is poised to experience the opposite of what it experienced on the way up, namely, the grim combination of declining profits and declining multiples applied to those declining profits.

8. Inflation and the Destruction of Secure Fixed-Income Investments

Most of the investors in the stock market should probably not have been there in the first place. The stock market is for people with the ability to read balance sheets and income statements and with the time and willingness to study specific firms and industries in considerable detail and then to follow them on a continuing basis. Even those who invest in mutual funds need the ability to judge the strategies and choices of the fund managers. In a free market, the reasonable place for most investors is high-grade bonds and mortgages, life-insurance endowment policies, and the like, i.e., secure fixed-income investments. Such investments, however, are reasonable only if the purchasing power of money is secure, i.e., if the monetary unit is a definite physical quantity of gold, not irredeemable paper money.

Because our monetary unit is now a piece of irredeemable paper, whose quantity the government can increase to whatever extent it likes and whose purchasing power it can correspondingly reduce, long-term fixed-income investments have been rendered far more speculative than common stocks. The purchasing power risk in connection with long-term fixed-income investments far outweighs the long-term risk of declines in stock prices when the potential is present for boundless increases in the quantity of money, which will serve to reduce the purchasing power of money as it raises prices, including, of course, sooner or later, stock prices.

Indeed, the degree of purchasing-power risk can be inferred from the almost total ignorance that exists of the quantity theory of money, which is the theory that explains the connection between increases in the quantity of money and decreases in its purchasing power. Even the majority of today’s professional economists, who at least have heard of the theory, do not accept it. And among the government officials with the power actually to increase the quantity of money-- i.e., the members of the Federal Reserve Board, and behind them, the members of Congress, who have the power to change the laws under which the Federal Reserve operates, and the President and key members of his Cabinet, all of whom have the power to bring pressure to bear on the Federal Reserve--those who clearly recognize that increases in the quantity of money is what reduces its value are few and far between. And then, among those who do recognize this fact, there is no assurance whatever that they will not sacrifice their knowledge of it to some momentary political advantage and help to bring about further rapid increases in the quantity of money.

In other words, what makes long-term fixed-income investments nothing less than a wildly speculative investment in today’s conditions is that their purchasing power depends on the knowledge and integrity of government officials, both of which exist in a range from minimal to zero. With respect to the future purchasing power of money, the government is in a position comparable to that of someone who is waving a loaded gun and is only dimly aware of the gun’s destructive potential and who, to the extent he is aware of it, is willing to fire it nonetheless, if he perceives some momentary advantage in doing so. Thus, it is no wonder that investors have flocked to the stock market. One way or another, they have correctly judged that it is the lesser of two evils in today’s world of irredeemable paper money. But still, it is fundamentally inappropriate for them to be there.

The presence in the stock market of a mass of ill-equipped, ill-informed investors may help to explain why the prejudice has taken hold that there is something immoral in buying and selling stocks on the basis of special, “inside” knowledge, i.e., knowledge not available to everyone at the same moment, and why acting on the basis of such knowledge has been made illegal. The presumption is that ignorance should not be allowed to put one at a disadvantage and that one should be able to profit without knowing what one is doing.

9. The Only Thing that Today’s Intellectuals Can See

In the financial whirlpool that sooner or later follows from credit expansion, many businessmen are put to trials they would never have had to face in the absence of credit expansion. Some are found wanting, as they try to save their firms and their fortunes by dishonest means, such as falsification of their financial statements.

The great mass of today’s intellectuals, of course, have no idea of the actual economic forces at work in connection with credit expansion. Not having studied the writings of Mises and other theorists of the Austrian and British classical schools, these forces are invisible to them, because they lack the intellectual framework that would permit them to observe them. Instead, they focus on the sins of businessmen. For that is all that they are equipped to see.

And here their ignorance of economics combines with an underlying mentality of such primitiveness that it recalls that of the wretched people of the Dark Ages or that of the members of savage tribes. In the Dark Ages and among savages, when calamities occurred, such as one’s hut being washed away by a flood, or one’s animals or family members falling prey to a disease, a typical response would be to blame the occurrence not on any natural phenomenon, operating according to scientifically lawful principles, but on the ill-will of an evil spirit, and to seek relief not in the better understanding and application of scientific principles but in the greater power of a benevolent, protective spirit. The only difference between then and now is that today’s intellectuals substitute for the good and evil spirits of savages and the Dark Ages, the great Gods “State” and “Government” and the Devils “Big Business,” “Capitalism,” and “The Profit Motive.” And in their ignorance and primitiveness, they seek to destroy the foundations of their own and everyone else’s material well being and very lives. For this is the meaning of their assaults on big business, capitalism, and the profit motive, which by the standard of man’s life and well-being are clearly good, not evil.

Small and narrow as the focus on the dishonesty and fraud of some businessmen may be, it nevertheless does have a real object. Unfortunately, it is overwhelmingly misdirected and totally ignores the truly massive fraud that is going on, which exceeds many thousand times over, all the frauds of dishonest businessmen, and which, as we have seen, actually occasions many of those frauds. This, of course, is the government’s systematic depreciation of the value of paper money and thus of each and every contract and security that is stated in terms of a fixed number of units of that money. What greater accounting scandal and coverup could there be than that the monetary unit, in which all accounting is carried on, is itself a fraud, a fraud that has robbed tens of millions of old people of a considerable part of the buying power of their life’s savings, that has destroyed the reliability of fixed-income investments as a vehicle for providing for the future, and threatens the value of all contracts. Where are the reporters and the congressional committees to investigate this horrendous situation?

10. The Further Undermining of Capitalism: the Assault on Stock Options

Among the features of capitalism that have come in for special attack as the result of the stock market bubble and its bursting is the fact that capitalism actually fulfills a major demand that used to be made by socialists (though not as the socialists envisioned its fulfillment). That is, it systematically turns the ownership of the means of production over to workers! These workers, however, are not the manual workers on factory assembly lines or their equivalent. Rather, they are workers who occupy key executive positions or who, without any formal title, by virtue of their position as existing stockholders, members of boards of directors, or even key lenders or suppliers, make a major contribution to the conduct and success of a firm and/or are in a position to see how its activities could be made more successful.

Such individuals are producers and they are workers, though their work is mainly of an intellectual nature rather than a physical nature. It is a work of thinking, planning, and decision making, a work of supplying guiding and directing intelligence at the highest level of a firm, not manual labor. In fields outside of business, such individuals are already credited with by far the main work in their undertakings. For example, history credits Columbus with the discovery of America. It credits Napoleon with the victory at Austerlitz. When people speak of America’s foreign policy, they speak of the foreign policy of the President and perhaps a handful of key advisers. 

History does not credit the crewmen who accompanied Columbus or the soldiers who served under Napoleon, and people do not credit the U.S. embassy employees or the other State Department employees. The standard of attribution in all these cases is the guiding and directing intelligence at the highest level., which was respectively supplied by Columbus, Napoleon, and the President. The crew members, soldiers, and State Department employees are all implicitly assigned the rank of mere helpers in the realization of the respective projects of Columbus, Napoleon, and the President.

If the same standard of attribution were applied in business, one would have to credit Ford and Rockefeller as the main producers of the old Ford Motor Company and the old Standard Oil Company. Contemporary examples, of course, would be Bill Gates of Microsoft and Andrew Grove of Intel. In every successful firm, some one individual or small number of  individuals is similarly at the helm, even if not so readily identifiable. It is to workers of this kind and to their major helpers that capitalism gives ownership of the means of production. Such workers must be given an important ownership stake if they are to have the incentive to achieve the success of their firms. And it is very much to the self-interest of all the other investors in firms, i.e., the stockholders who play no active role in the conduct of their firms and the various creditors, that this occur.

Moreover, workers of this type are in an excellent position to acquire such ownership. In a free market, they can acquire it by virtue of such things as insider stock trading and accumulating and investing the profits therefrom. (This, of course, is now illegal.) They can acquire ownership by saving out of the high salaries they earn and using those savings to buy stock in their firms. But this avenue too, it must be realized, has now been largely blocked, first by confiscatory income taxation and more recently by an effective congressional limit of $1 million imposed on the salaries of corporate executives. (It is still legal for corporations to pay executives salaries above $1 million, but the excess does not qualify as a business expense. The corporation must treat it as taxable corporate income.)

There has remained a further means by which the right workers could become owners of the means of production, and which is now under major attack. This is the granting of stock options.

It may be that excessive reliance on stock options is unwise, because stock options do not balance the prospect of profit with the fear of loss, since the option holder does not yet have anything to lose. It may be that the firms that grant options should require the recipient to continue to hold the shares he obtains by their exercise for some protracted period of time thereafter.

These are matters of trial and error, as are the best procedures for safeguarding the accuracy of financial statements. They should be left to the market. Those firms that implement a better options policy will be more successful and in the long run their stock will do better. Their stock will do better immediately to the extent that they implement an options policy that the stock market judges to be better. Likewise, their stock will do better immediately to the extent that they institute accounting procedures that the market is convinced it can trust.

Different firms must be free to adopt different procedures and to change procedures previously adopted, so that better arrangements can be developed and become more widely adopted. The stock market itself will appropriately reward and penalize, if it is not diverted by manias induced by credit expansion. What must not be done is to make the decision about options and accounting policies the monopoly privilege of a gang of lawmakers, who notoriously do not even trouble to read the laws they vote to enact and who knowingly enact vague, contradictory laws on the premise that the courts will somehow sort them out. Even if the members of such a gang were all sober and fully awake and making their conscientious best efforts, and were a lot smarter than they actually are, they would have no claim to any kind of monopoly privilege on the subjects. As matters stand, the results they are actually likely to produce will almost certainly be very poor indeed.

The main argument currently being offered to limit the granting of stock options, and which Congress is being asked to accept, is that the granting of stock options should be treated as entailing a business expense. For example, an option is issued that entitles the recipient to buy 1,000 shares of a firm’s stock at a price of $40 per share. Thanks in significant part to the option recipient’s efforts, the stock price advances to $100 per share. The recipient now exercises his option, buys 1,000 shares at the option price of $40 per share, and receives stock now worth $100 per share. The option recipient has profited to the extent of $60,000. The enemies of options argue that because the option recipient has been compensated to the extent of $60,000 and the firm could have had this $60,000 if it had sold the 1,000 shares at the current market value of $100 per share, it must report $60,000 of additional costs and reduce its reported profits by $60,000.

The enemies of options apparently see no difference between profits and wages. They proceed as though the compensation of the option recipient were that of a salaried employee. It is not. It is essentially a form of profit. And it is given to him as an incentive to increase the firm’s profits, which the kind of work he does puts him in a position to do if he is properly motivated. The enemies of options, of course, also overlook the fact that in the absence of the option recipient’s efforts, the firm would not have had the ability to sell its shares at $100 per share. It is precisely the efforts of the option recipient, motivated by the prospect of profit, that are responsible for  the stock getting to $100 per share. When successful, the effect of the granting of stock options is to increase the profits and capital gains of all concerned. Thus, for example, if our option recipient gains on 1,000 shares out of an overall total of a million shares outstanding, the gains to all the other stockholders far outweigh the gains to him. The process has not only not cost the corporation or the other stockholders anything, but has positively profited them.

The above, to be sure, applies to the workings of stock options in the normal course of events in a free market. As we have seen, credit expansion causes an artificial surge in profits and in stock prices. In the face of existing option arrangements, it showers financial benefits on the option holders which they in fact have not created and, indeed, is capable of giving them enormous unearned incomes. But it does exactly the same thing for the great majority of stockholders in general. And when the bubble breaks, it is not the institution of stock options that is responsible, but credit expansion and its necessary cessation. Nor is it the fault of the option recipients that they are often considerably smarter than the great mass of investors and may have had the good judgment to withdraw their gains from the stock market before the bubble burst. This combination of circumstances explains how it is that executives can sometimes enjoy incomes based on the exercise of options that are hundreds of times greater than that of the average worker and do so even in the same year in which the mass of stockholders suffers enormous losses.

But even in conditions in which the option recipients’ efforts are not responsible for the rise in stock prices, it is absurd (and dangerous) to introduce the principle that business is to regard as a cost a gain that has been foregone, i.e., a so-called opportunity cost. The fact that a firm might have sold shares at $100 instead of the $40 it has agreed to, is not at all a cost in the sense of the funds the firm actually expends for means of production. Its alleged cost-character is a phantom of the imagination. Adopting the principle implies that if an investor puts $1 million into Stock A, whose price proceeds to double, but might have put $1 million into Stock B, whose price proceeds to triple, he has lost $1 million dollars and perhaps should jump from the nearest skyscraper. On the other hand, if the price of Stock A proceeds to fall in half, while that of Stock B becomes altogether valueless, he is to regard himself as having gained $500,000, because he now still has $500,000 while he would have had nothing at all. Perhaps he should buy a new car, to celebrate.[10]

If today’s intellectuals and politicians were not so thoroughly anticapitalistic in their mindset, and they wished to see accounting changes take effect that really would make reported profits a better indicator of the actual results of firms’ activities, what they would advocate is allowing firms to reduce their reported—and taxable—profits by an amount reflecting the rise in the replacement prices of assets over the accounting period.

As matters presently stand, the government’s inflation creates paper-money profits a major portion of which is required merely for the replacement of assets at higher prices. Taxing firms on such profits is tantamount to taxing them on their original capital, not genuine income in the sense of a real gain from operations.[11] This is a major aspect of the accounting scandal I referred to earlier that is present in the use of irredeemable paper as the monetary unit in which accounting is carried on, and which such a change would address.

That would be an accounting change that would serve to increase production and raise the general standard of living. But as it would enrich the hated capitalists and reduce the loot drained away by the beloved government and its tax collectors, one should it not expect it to become widely advocated or seriously entertained any time soon.

The present boom-bust cycle and its significance cannot be better summarized than by these words of Mises in Human Action:

“Nothing harmed the cause of liberalism more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy. People did not conceive that what they lamented was the necessary outcome of policies directed toward a lowering of the rate of interest by means of credit expansion. They stubbornly kept to these policies and tried in vain to fight their undesired consequences by more and more government interference.”[12]

More and more government interference to combat the consequences of the government’s own policies! Precisely this is what is going on now. But perhaps this time, thanks to greater knowledge of Mises’s ideas and their wider dissemination, there will at least be a serious fight to stop it by means of teaching the public the truth.

*Copyright © 2002 by George Reisman. All rights reserved.

**George Reisman, Ph.D., is professor of Economics at Pepperdine University’s Graziadio School of Business and Management and is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). 

  Return to Top of Page