The Three Types of Marginal Capital Allocation

As we discovered before, the marginal decision on cashflow re-allocation drives cyclicality.

There are principally three types of capital allocation transactions.

If you are expanding capital stock, or you are funding the expansion of capital stock, you are investing.  This includes net fixed investment, the purchase of newly issued marketable securities which fund new investment, or otherwise funding ventures which do. Purchases of existing shares on the secondary markets, such as the purchase of stocks and bonds outside of IPOs do not represent investment, but simply swapping the ownership between the cash and security holders.

If you are underwriting convexity risk to capture theta, you are providing liquidity. You needn’t be doing this with options.  Any portfolio instrument or stance that pays an expected time premium for adopting convexity risk will do, whether it be buying a stock which has a temporary disconnection from fundamentals or shorting volatility instruments.

If you are doing neither, you are simply trying to exploit a monopoly on existing capital.  This can be accomplished by owning existing fixed capital assets and selling the output, or by ownership of securities which stake a claim in ownership of existing fixed capital assets and income.  The value of existing capital is relative to the supply of existing real capital to meet present demand for output.  This is most profitable when there is an existing deficit of real capital from inadequate past investment relative to present demand.  The value is bolstered by the frictions to competition by new investment to expand capacity.

While investment is the only non-rentier transaction type, the provision of liquidity, particularly during times of market dislocation, generates value by raising the unrealised equity value of other holders, thereby freeing their capital to service something more productive.  However, if the liquidity provider previously had liquidity preference — that is, he developed his monopoly on capital by first hoarding it through non-reinvestment accumulation — this reverts to unproductive behaviour on balance.

The decision to allocate like a rentier is not entirely autonomous.  There is a realistic limit to the amount of fixed capital which can be profitable and manageable by the agency of a single individual or household.  The purchase of securities (or shares) to defer the management of fixed capital thus also defers the decision to be a capitalist or a rentier.

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4 Responses to The Three Types of Marginal Capital Allocation

  1. Benign Brodwicz says:

    In story form: when financial capital (ownership of “physical capital” aka the means of production) becomes too concentrated, a “failure of effective demand” occurs as the owners of the means of production lower wages to the point where consumption spending begins to fail; this depresses “animal spirits” quite rationally because most [true] investment demand is a derived demand (from consumer demand); hence the preference among those owning the means of production in the form of financial capital to prefer rents and speculation (with their cash) over investment in “physical” capital; through influence the rentiers lower capital requirements and create an inherently unstable monetary structure, within which they fight like pirhanas over speculative opportunities, which leads to a cycle of intermediary collapses, extreme monetary base creation, and bailouts using sovereign powers of taxation to pass the loss along to the people; once trust on the monetary unit vanishes, perhaps with an expropriation of deposit funds, the stage is set for (1) deflationary collapse, as bank runs overwhelm the deposit insurance system, and (2) hyperinflation, as the monetary authorities order banks to issue prepaid debit cards to anyone wanting to withdraw his or her money from the bank.

    The structural reforms needed: no more (or much higher reserve level) fractional reserve banking; steeply progressive income and, for a time, wealth taxation to restore a healthy circulation of income and product. See Emanuel Saez’s recent interview on this at http://www.bostonreview.net/BR38.1/emmanuel_saez_david_grusky_income_inequality_taxes_rent_seeking.php

    Marx has the last laugh.

  2. Gross fixed capital formation for maintenance of existing capacities at the same level is investment due to replacement, intensification and rationalisation of production, but without expanding the existing capacities or fundamentally changing the present technology.

  3. An owner can obtain funding for purchase of fixed capital assets from the aptly named capital market , where loans are given on a long-term basis. Funding can also come from reserve funds, the selling of shares , and the issuing of debentures , bonds or other promissory notes.

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