INVESTMENT: STOCKS & BONDS This chapter examines capital markets: why do individuals, firms and governments seek to raise capital to support their productive activities
1.1 WHAT IS CAPITAL? In a simple model of the economy there are three factors of production: land, labor and capital. The first two are relatively straightforward and intuitive: land consists landed property and the natural resources contained there in, while labor is human activity. However, what “capital” is less clear. In economics, the term “capital” is often specified to refer to the type of capital under consideration. For example, buildings, equipment, and tools may be called fixed or physical capital, while money is financial capital, skills as human capital, and social networks and relationships as social capital. It is not clear that one unit of capital in the form of skills is readily equivalent to one unit of capital in the form of money or to one unit of capital in the form of technology or equipment. Therefore, when we discuss “capital markets” in the abstract, we need to keep in mind that we are sometimes conflating different things. The failure to understand confusion on the part of economists and economic thinkers as much as our own shortcomings. Unlike other basic factors of production, such as labor and land, where the units are more commensurable, capital may not. In addition, while the other factors of production are just “there,” i.e., not produced, capital must be made. For example, if I want to make a simple tool, I might combine my labor (work) with raw materials (wood, metal, etc.) taken from the land to make physical capital in the form of a hammer. If this is true, then the value of the capital (hammer) should be the simple sum of the value of the land and labor inputs. However, this is not true. There is a positive return to capital -- a positive interest rate -- that suggests there is an uncounted increment of value in capital that is not reducible to its inputs. Understanding the origins of this increment is key to understanding the operation of capital markets because it is that increment of value that creates the ability to “make money from money” through financial transactions. Since one of the key insights of economics is that there is “no free lunch” -- everything must net out -- uncovering the origins of this increment is key to understanding why economies can grow over time and the distribution of resources and income. In Marxist language, it is the “means of production,” i.e., the tools required for productive activity. Those that control the technology, money, and equipment needed for modern economic activity have power over those who bring the other factors -- labor and land -- to production. To more conservative “Austrian” economic thinkers, capital is simply the passage of “time.” The real interest rate -- the price of capital -- simply discounts the value of purchasing power between two periods of time. For example, most people would rather have $10 now than $10 a week from now. The difference is the implied interest rate, the cost of money. As a result, we pay a preimium -- an interest rate -- to borrow money to be spent in the present against money delivered in the future. To economic thinkers and moralists of the Middle Ages, this made no sense. If money is simply a measure of value, how could anyone profit from lending money: how could anyone lend an inch? The reality that we, without thinking it strange, use a variety of capital instruments -- checks, credits, automobile and mortage loans, and fiat currency defines the modern age.
2.1 STOCKS AND BONDS Stocks and bonds are two instruments for financing current consumption and investment. However, most individuals do not use either stocks or bonds to make consumer purchases or to finance major investments such as the purchase of a home or a car or to pay for a college education. Why not? Or, why do