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What is Capital?

By James H. Nolt

“Capital” is a very common term in economics. Like many folks, I have referred to the contemporary economic system as “capitalism.” Yet the terms “capital” and “capitalism” are so often confused, not the least by economists. Their confusions are taught in textbooks, leading to broad confusion throughout the society and public media. Next week I will focus on capitalism; this week I will tackle capital itself.

Economics textbooks introduce capital as a “factor of production,” along with land and labor. I like to call capital in this form “physical capital,” though “productive capital” might be a better term because some of it—such as algorithms used productively—are not, strictly speaking, physical things. Common forms of physical capital include factories, mines, plantations, ships, railroads, office buildings, and commercial aircraft. Economists emphasize that physical capital is used, in combination with the other factors of production, to produce everything else we desire, including more physical capital. Physical capital also pays income to its owners in the form of profits.

Yet textbooks also emphasize that physical capital has alternative uses. That is, it can be allocated to produce any of a vast range of possible goods and services. This proposition is fundamental to the entire design of neoclassical economics, which emphasizes choice under the constraint of finite resources. In this case, the choice is what to produce with your physical capital.

Some physical capital does have broad alternative uses. A computer or electric motor, for example, can be useful in a wide range of productive endeavors (though not all). However, most installed physical capital has only one use or a narrow range of uses. In its physical productive form, it cannot be reallocated to produce something else. For example, a passenger train is physical capital, but its use is limited to transporting passengers along specific railroad tracks. A textile mill might be able to weave various kinds of cloth, but it is useless for producing anything else. So in fact, most physical capital is not the fungible productive blob treated in textbooks, but concrete equipment with specific uses.

Economists are less precise in specifying another form of capital that does have myriad alternative uses: what I call “money capital.” Money capital is liquid investable wealth. It may include not only what accountants call “owners’ equity,” but also credit, a.k.a. “other people’s money.” Capital in such money forms is not physically productive. It produces no new output itself. Money capital is most like economists’ textbook definition of capital, insofar as it does have an infinite variety of alternative uses. These may include being spent to buy physical means of production, such as automatic looms to weave cloth. However, as long as the money capital remains liquid, it produces nothing. Only when it is committed to a specific productive enterprise may it actually function as physical capital, but then it no longer enjoys the flexibility of alternative uses attributed by economists to capital.

Furthermore, money capital need not be invested in physical capital at all. Much of it is invested in purchasing assets, including real estate and financial products like stocks and bonds. In such cases, the capital earns income, but still may produce nothing. The owners of financial assets get paid even if their portion of capital produces nothing at all, as in the case of bonds issued by governments to fight wars. Economics treats all capital as productive capital, but much capital invested in financial assets has never been productive of anything, yet it still gets paid.

For example, suppose a farm is valued at $10,000 and produces 2,000 bushels of wheat per year. An investor issues a bond to buy the land, and the farmer pays rent to this new landlord. (Perhaps he sold the land to cover a debt.) A few years later, credit has been expanding bullishly and another investor buys the same farm from the first one for $20,000 by issuing a larger bond. He might increase the farmer’s rent to maintain coupon payments of similar percentage on the larger bond. Even if the farm’s output is the same, a larger share of it is now paid in rent as the land price has doubled. This illustrates how the expansion of credit can lead to larger and larger financial claims against the same physical output. Such capital is not productive, but parasitical.

The earliest ideas of capital were related to domesticated seeds and animals, such as cattle. The 18th century political economists, called “physiocrats,” considered seeds and domesticated animals as the only real capital. Their natural reproductive power enabled them to grow in quantity over time, thereby constituting the physical basis of the return on capital. Thus physiocrats considered these products of landed wealth as the only true source of national growth. They argued that urban and mercantile activities merely transferred the form of wealth without adding to it. For example, the value of cloth produced by weavers was, for physiocrats, identical to the inputs, including the raw materials, tools, and the sustenance of the workers.

Adam Smith criticized the physiocratic idea that only living capital (seeds and cattle) created expanding value. Actually, Smith did not yet use the term “capital,” but still referred to it as “stock,” reflecting the origin of this term as a collection of cattle. Smith, writing at the early stages of the industrial revolution, believed that the division of labor in factories and the machinery employed therein also created expanding value. He was a champion of capitalist industrialization. However, he did not believe that financial capital was productive. He considered it parasitical.

During the latter half of the 19th century, as economics began to displace the political economy of Smith and others like David Ricardo, John Stuart Mill, and Karl Marx, the idea of capital became more muddled. On the one hand, economists have always insisted that capital is something productive that has alternative uses. On the other hand, they often ignore money and nearly always ignore credit, so it must only be physical capital. The amorphous concept of capital within economics has the flexibility of money capital but the productivity of physical capital, without firmly identifying with either. It is a Frankenstein monster of myth, not anything specific or concrete. Economics has actually lost the specificity of capital one finds in Mill and Marx.

Piero Sraffa, a famous Cambridge political economist, tried to revive the richer classical view of capital with his 1960 book, The Production of Commodities by Means of Commodities. Sraffa and his followers are often called “neo-Ricardians,” since they revived the concept of capital as specific physical means of production used by David Ricardo, but employing more mathematically sophisticated models using linear algebra. During the 1960s, Sraffa had a long-running debate with Paul Samuelson at MIT, who defended the amorphous neoclassical view of capital still found in textbooks today. This debate is often called the “Cambridge Capital Controversy” because Sraffa was from Cambridge, England, and Samuelson from Cambridge, Massachusetts. Arguably, Sraffa won the battle with better arguments, but Samuelson won the war, because neoclassical economics triumphed anyway, despite an amorphous and illogical theory of capital at its heart. By the way, neither side in the debate took account of what I emphasize in this blog series, which is the dominant role of credit in the self-expansion of capital. More on that next week.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of 401(K) 2012]


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