Capitalization, Entrepreneurs, Income, Investments
( Originally Published 1918 )
In strict definition, capital is the dollar value of that which produces a definite net income.
In finance it means the sum of securities that yield a rate per cent in the form of interest or income. In commerce or industry it means the dollar value of any business yielding a definite rate per cent of profit.
As applied to the bulk of business, and in cases where a business is sold, the sales price will be a sum which is ordinarily called a five years purchase; or a ten years purchase or a purchase covering any agreed number of years. That is, its dollar value for the purpose of sale is deter-mined by the aggregate net earnings it will make in a given number of years. Thus, a business producing a net income of $5,000 a year, the capital sum or sales figure would be, at a five years purchase, $25,000.
In finance, any security having a long course of years to run and bearing five per cent would be marketed at par so long as it produces and pays five percent. Should it rise to a yield of ten percent its dollar value would be double par. Should it decline to two and one-half per cent, its dollar value would decrease accordingly. Such fluctuations are automatic.
It sometimes occurs that a small capital value will earn abnormal dividends. For instance, the Calumet and Hecla Copper Company for many years has paid dividends up to and sometimes over 500 per cent. The dollar value of the capital stock appreciates accordingly, and the shares are dealt in on the Boston Stock Exchange at values rating upon a basis of six per cent.
On the other hand, some corporations whose large capitalization was first maintained at par declined in dollar value when the dividends began to decrease, and continued to decline until all of the water was squeezed out of the stock, and then at a reduced dollar valuation returned to six per cent.
Actual Wealth is the value of lands, machinery, or goods, and is ascertained by applying the principle of earning power.
Goods are in two classes: first, production goods, the utility of which is indirect or must be expressed in terms of its power to produce to direct utility. The value of production goods is wholly dependent upon the value of the consumption goods to the product to which they contribute.
The same principle applies to labor, and to the mechanical processes by which labor produces merchantable results. Labor engaged in producing things that have a falling value, must suffer a corresponding decrease in the wage scale. Machines, no matter how much they may have cost, lose value whenever they are supplanted by better machines for the same purpose.
Methods of Coordination. In the necessity for stabilizing product and consumption goods on the market, two systems of marketing are employed. The cooperative system and the entrepreneur system.
By the cooperative system, the owners of the factory or other means by which consumption goods are produced join with their employees in the work of production and share with them ratably in the profits. This system is necessarily limited in its operation. It can not be nationally made to include the whole of any one production industry. For that reason the entrepreneur system is the one most broadly used.
The dictionary meaning of the word "entrepreneur" is given as "one who organizes and directs industrial enterprises." In application the meaning is broadened. Jobbers and wholesalers are entrepreneurs. In its large application the word entrepreneur has been replaced by the word "promoter," for the promoter is one who organizes combinations of industrial enterprises, al-though not always the one who conducts them after organization. The entrepreneur now is the the man who undertakes responsibility for an organized industry, fixes rates agreed upon and the capital required, as well as the wages and salaries of those employed. He is really the one essential middleman. His function might be described as similar to that of the gasometer in a system of municipal gas supply, which acts as a governor or equalizing float between the out-put of the gas works and the flow of delivery to the consumer. In discharging this function he gathers his remuneration from the difference between the gross cost of product and the gross receipts from sale. Out of that difference he must take his own operating cost. After this deduction, the remainder is his profit.
Since his business may entail outlay at low points of fluctuation in volume, or an occasional loss or monetary advance in the handling process, he must have a reserve or safety fund of his own. If this fund is sufficient to impart responsibility, his business becomes assured, and is invaluable to producer and consumer alike. It is especially valuable to the dealer through whom the products must pass by retail to the ultimate individual who buys and uses them.
Generally speaking, the entrepreneur arranges credit, usually with a bank but sometimes with private capitalists, by means of which he can command from time to time such funds as may be needful for emergencies, or for immediate purchases, or other uses.
For a demonstration of this subject, the Standard Oil Company may be cited as a complete entrepreneur. It has organized and consolidated the industry of producing, turning into forms of consumption, and marketing petroleum and petroleum products in all their various forms.
Personal Income in its strictly legitimate definition, is the fruit of one's own productive effort of whatever kind. But if it were confined to that meaning, incentive would disappear, and the world would retrogress, for new inventions or enterprises would dwindle or cease.
The man living upon income not personally created or earned has social and economic value in that he stimulates the circulation of money, which finds its way to its natural level in the uses of trade and industry.
There being no law of primogeniture in this country, nor of entail, perpetuation of family fortunes is impossible. Three or four generations will in nearly all cases cover the history of any family "from shirtsleeves to shirtsleeves." A moneyed class has been created, but its member-ship changes continually, and events that now are Milking human society from its old foundations and tumbling its structure apart will be succeeded by new foundations and a new structure, concerning which the only thing we can be sure of is that they will be better than the old. Better because the incrustations of centuries will have been cracked beyond the possibility of re-pair, and the new structure will be completely democratic.
Money Income: The cooperative system in production goods as a creator of income has not been widely accepted, because most participating producers, instead of taking their shares of out-put in production goods as income, have preferred to let the product pass into the form of money or credit to be used for its purchasing, power, and kept at work. In this way they unconsciously increase the sum total of active capital for the movement of production goods other than those they helped produce. Such an investor, by assisting a market for such goods (no matter how indirectly), stimulates trade by helping make room for other goods to take the place of those he has caused to be moved. He becomes a contributor to massed capital, and in turn an investor of personal income.
Methods of Investment. A very small proportion of the savers or of the original creators of capital are capable of investing it themselves. The merchant may use a part of his income to increase his stock, or the farmer to buy new implements or stock, but probably the greater part of all saved capital is turned over to other entrepreneurs for investment. There are a number of methods by which the capital is transferred from the saver to the control of the entrepreneur who requires production goods.
First, the saver may deposit his savings in a savings bank, thus making the bank his agent for the investment of the sum. The savings bank will perhaps buy bonds of a corporation, which thus obtains the capital and expends it in improvements or enlargements.
Second, the saver may deposit his savings in a commercial bank, in which case the capital finds its way into the hands of commercial borrowers of the bank and is used as working capital to buy raw materials, to pay wages and to carry customers' accounts for short periods. Third, the saver may himself buy stocks and bonds from a bond house or a trust company, and thus make these institutions his agent for investment. Fourth, the saver may hoard actual cash, which simply means that investment is postponed for the time being.
True Investment. In the ordinary use of the term the purchase of stocks and bonds in the market would be called investment, but it is not true investment. In this case the saver has simply shifted to the seller of the bonds the responsibility for the real investment of the capital, that is, the responsibility for converting it into production goods. It is only when the capital enters upon active utility in the hands of the entrepreneur that a real investment can take place. Entrepreneurs are constantly bidding for the use and control of this new capital, which is as constantly accumulating. The entrepreneur who can offer the best rate of interest or the highest dividends with the best security has the advantage in this competitive bidding.
Under modern conditions of industry the large corporations are likely to be able to use this capital to the best advantage, and hence are in a position to make the most attractive offers to savers. Therefore, there is an increasing percentage of the savings of the community flowing in that direction. This is to the public advantage, in so far as the corporation is able to utilize the production goods to which the capital gives them claim, and the final result is an increased amount of product. For this reason, any system which facilitates the flow of capital from the savers into the hands of the most efficient entrepreneurs is a distinct economic gain. All the highly specialized financial institutions perform this economic service, and their productivity, indirect though it be, is to be measured by the increased efficiency of the capital which they have diverted into the most productive field. The stock exchanges, the financial and commercial banks, trust companies, underwriting syndicates and all the machinery of high finance are economically beneficial to the country in the degree that they perform this function.
Hoarding. When the storing away of money becomes excessive, it is described hoarding. It would be difficult to attempt to draw the line where hoarding begins. The amount of money prudent people will have ready for necessary purchases and the payment of debts will vary widely under varying circumstances. In the panic of 1896 the country banks all over the country withdrew their deposits from the New York banks in order to be amply protected in case of large sudden demands from their depositors. A great many banks carried this practice to an unreasonable extent, and filled their vaults with money for which they had no use and for which there was likely to be no use except in the case of most extraordinary disaster. Such storing away of money is properly called hoarding.
Decline of Hoarding. Steady progress in the direction of improving the financial and banking systems and widespread education of the people in the advantages of dealing with banks has diminished hoarding in this country until under normal conditions it is practically limited to per-sons in rural districts and to a few eccentric individuals who are willing to run the risk of robbery in order to enjoy the satisfaction occasionally gloating over a pile of coins or of yellow-backed paper.
But it is easy to frighten people out of their banking habits and cause them to revert to the more primitive methods. The failure of a prominent bank or the exposure of unsavory methods in high finance will induce a great many timid per-sons to withdraw their money from banks and stow it away in safety deposit vaults, or in some hiding place in their homes. The stocking and the old coffee pot as fiduciary institutions have not yet wholly passed away.
Bank Reserves Not Hoards. The enormous sums of money stored in the vaults of banking institutions are not hoards in the ordinary sense of the term. These dollars are really supporting credit, which as a substitute is doing the real money work. In fact, an idle dollar in the reserve, backing up credit, is really doing four or five times as much work as its brother in circulation.
Government Hoarding. While the great sums in bank reserves are not hoards unless they should be excessive, there are at times huge amounts in the Government treasury and sub-treasuries which really are hoards. The law requires that $150,000,000 in gold shall be maintained in the treasury as reserve against the paper currency outstanding. This is a true reserve, not at all a hoard. Furthermore, the gold and silver, both coin and bullion, which are held in the treasuries and against which gold and silver certificates are circulating, are not hoards. The paper money which represents them is doing their work by proxy. But unlike the bank reserve, which through its substitutes does four or five times the amount of money-work, the gold and silver certificates do no more than gold and silver itself could have done. The only advantage derived from the system is the greater convenience and the saving of the wear that continuous handling would inflict on the metal.
Another part of the money held by the government represents a store of cash ready for future expenditures. This is the sum necessary to be kept on hand in order to provide for purchases within a short time, just as individuals find it necessary to keep a certain amount of cash on hand for the same purpose.
Any amount of money held in the treasury beyond the sums mentioned above is a hoard, unless under the exceptional conditions of war, and would represent purchasing power withheld from circulation and for the time being useless.
Discrimination in Demand for Money. The different forms of demand for money do not apply at all times equally to all the different varieties of money. In some circumstances, the demand falls upon one kind alone. So long as all the different forms are kept at parity the demand for a circulating medium to exchange goods or to liquidate debts is satisfied with either form. The question of convenience sometimes arises, as in the case of the silver dollar after the silver purchases in the eighteen hundred and eighties. These silver dollars refused to circulate in the quantities desired because the people had learned to prefer paper on the score of convenience. They would refuse to take them from the banks and would deposit them freely; the banks would turn them back to the treasury in exchange for paper which their depositors demanded. The government even went so far as to pay express charges to distant points in order to keep the silver dollars in circulation; and finally the ingenious plan was hit upon of storing away the silver dollars and issuing in their stead silver certificates of one and two dollar denominations which were circulated in their place.
Seasonal Demand for Money. For 90 percent or more of the domestic exchanges no money is required at all, bank credit in the form of checks and drafts serving the purpose. This relieves the money of the country of most of the demand, but there are circumstances when this bank credit fails to do its work. During the crop moving sea-son in the south and west there is a demand for a medium of exchange which cannot be supplied by bank credit. Every autumn there is likely to be a demand for about $150,000,000 or more extra money to finance the crop moving. This money must ordinarily come out of the reserves of the banks, causing a contraction of credit, after credit has been expanded and may give rise to temporary stringencies in the financial centers.
These seasonable demands with their accompanying discomforts arose out of a habit the country banks had of depositing in the great city banks not only a portion of their reserves at certain times of the year, but a large proportion of their additional cash. The city banks, especially those of New York, paid interest on these country deposits, and were obliged to keep them in a state of active loan. Because these country deposits were subject to demand, the loans also had to be made on demand or call. The only available field for such activities was the stock market; so that whether they meant it or not, the country banks became promoters of speculation.
To a large degree this custom has been curtailed by the elastic note issue made possible under the Reserve Bank System, which has considerably stimulated the country bankers' purchase of commercial paper, and in that way diverted much of the money from use on the stock exchange.
Government Deposits. During the panic of 1907, the Treasury at Washington not only issued government bonds as a basis for government de-posits, but also accepted other standard bonds for the same purpose. Up to that time the government would deposit surplus money in national banks only when the deposit was secured by government bonds, and none other. The Secretary of the Treasury took upon himself responsibility for the change. It was found to be so effective and so safe that it was legalized by the passage through Congress of what is known as the Aldrich Vreeland law. This law, next after government bonds, gave preferential choice to certain classes of municipal bonds. The Aldrich-Vreeland act was found effective in holding the position until the Federal Reserve Bank law came into being.