Just to sketch out here an early version of a model im working on to show the direction of travel and some of the issues/problems that it throws up.
This model is very classical in inspiration with factors of production owned by people – classes in the classical terminology – each earning a factor return.
Of course as Adam Smith stressed an individual may receive more than one factor return in a business and this can be the source of much confusion.
The model is as follows:
|Physical Capital (physical means of production)
||Capital Goods Rent
|Credit (Debt Financing)
||Loan Repayment (Interest+Principal)
So this is treating money (financial capital) separately from physical capital. This investment profit can be financed from accumulation but is more likely to come from banking credit.
Note we talk of loan repayment rather than interest as a factor. This would be a mistake. Interest is revenue from the rent of money, and investment is the rent of money, but as well as revenue there are overheads associated with the business model of banking and interest must also cover anticipated inflation. So interest is profit determined, sufficient by itself to disprove pure time preference approaches to interest rates. Pure Time preference may affect how yield curves on investment are discounted but by itself cannot explain how interest rates changes when profit expectations change (Pure Time preference is single dimensional when it should be two – profit over time – related to the the area under yield curves)
What then do we mean by investment? We are trying here to understand the double transactions in each investment decision and the double entries made from each.
Consider an entrepreneur with limited savings which is forced to borrow to make an investment in physical means of production. They go to a bank which makes a loan secured on collateral, the capital goods bought.
Assume the loan is for 10 years but the capital good has a longer period of durability than that – unknown but longer than 10 years. The firm will make a capitalist profit if its costs
Wages +Rent + Loan Repayments (principal + interest) <revenue
Now an immediate issue that arises here is what does loan repayments have to do with marginal productivity of a ‘factor’ ? If the investment was funded through accumulation (Crusoe type savings) then the principal payment would simply be the return on renting money to yourself – or put another way the opportunity cost of the use of that money elsewhere – adjusting for risk. But if you have to borrow then you will have to pay the rental cost of that money over the period of the investment, also adjusted for risk and including any overheads. So we can talk about marginal productivity if we separate out principal from interest – but for interest it is less straightforward.
Now lets look at money flows over the period of the loan. There will be a period before revenue is earned yet where capital goods and rent and wages costs must be paid for – what Austrians called the ‘pool of funding’. Then there is a period when revenue comes in and you continue to pay costs including loan costs. Assuming (for sake of simplicity) a fixed rate loan then simply being cash flow positive is not sufficient to say that the investment ‘paid off’ and the firm is in the black. The cost of the ‘pool of funding’ is growing all the time even after revenues commence (this is similar to the concept of the burn rate of capital). A firm is in the black if its profits – before loan repayments – are greater than the financing costs of the pool of funding, but it can fall back into the red at any time. Then there will be a period when more and more of the loan is repaid and the firm will make more and more profits. Once the loan is paid then the firm will own outright the capital good and all income from it is pure economic rent.
A few consequences of this approach.
Firstly by separating out the financial capital and stock of capital goods it avoids the confusion of treating capital as a single factor subject to a single marginal productivity.
Secondly we can see the role of debt in bridging the differences in wealth between those who want to invest but have limited wealth and those with wealth but limited investment opportunities.
Those with some wealth but insufficient to make the investment will seek loans or equity to bridge their liquidity gap. Those with insufficient liquid assets to invest but sufficient illiquid assets may sell them. Banks with sufficient liquidity and profitability may loan to fill the remaining liquidity gap.
Investment then requires adjustments in liquidity positions between the factor holders. The rate of interest will reflect the supply and demand for money of the different parties, their liquidity gaps.
Finally for durable capital goods unencumbered by debt it is very difficult to talk of marginal productivity – its pure profit, and even the opportunity cost if lent out to some other party, would be pure rent.
On the last point you might argue that competition new entrants would lead to declining profitability so that in pure competition the returns on capital goods would equal the costs of money to finance them. This ignores however that early entrants to a market are likely to create superprofits, that this will attract finance, but because of the time gap profits will be driven down and later entrants will make less or no profits.
Given too that banking interest will be a function of the capitalist profits can be made it is difficult to talk of marginal productivity for loans either. You can talk about marginality in relation to alternative investments of the same unit of money (the Keynes approach) but the ultimate source of the factor return is the ability of bankers to extract an element of the surplus because of a shortage of accumulated debt free investment funds.