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Money and Capital Reconsidered

Money, capital, interest and profit are pivotal concepts in the science of economics. For a clear understanding of how they interrelate we need to ask the simple question: What is a ‘firm’? Laws and regulations are primarily intended to keep order in society; a corollary function is the production of legal entities, with specified rights and responsibilities, which supply numerous kinds of goods and services that a community wants. These entities are sometimes related to real entities, i.e. human beings, and at other times to socially-produced entities. Our concern here is with the commonly known entity of a firm as an institution. The goal of a firm, more precisely, of its stockholders, is to earn profits. Every essential component of a firm, i.e. factors of production, is expected to receive its share of those earnings. In capitalism, labour, capital, and land would receive wages, profits, and rent, respectively. These entitlements are made possible only in the framework of the institution of the firm. No amount of people owning any amount of money can expect to earn anything unless and until they have entered into the legal process of establishing a firm. Loan, a social contract, is another institution for which two parties are needed to sign the contract. This contract, although typically entered into for a period of time, is not of the kind where the lender, sometimes bondholder, can expect any share in its working, even if the loan is used in establishing a firm. Having a share in the working of ‘money’ is possible only when the possessor of money decides to go through the legal process and instead of becoming the bond-holder becomes a stockholder of the firm. This is the only way the bond-holder can claim a share in the profits of the firm. This distinction is central to our discussion. The failure to distinguish between these two institutions has been the source of much confusion in the economic literature because it has rarely, if ever, been properly and sufficiently noticed.

Providing money to a firm, as a loan, is not the same as supplying capital. Although the bond-holders do not have any right over the workings of the firm even if the money loaned is used to buy assets, they do have the right to claim the principal plus interest charges, even in the event of the firm’s bankruptcy. It appears to preserve some balance between rights and responsibilities in that they are not given any right to vote in the firm or claim any share in the profits, while they are entitled to get their loan back. There is a balance apparent too in the rights of the stockholders. They are the owner of the firm and all the profits earned by the firm are theirs. Furthermore, they are the only ones who have the right to vote in the firm and enjoy exclusive claims over the profits. Another distinction that needs to be made is about risk taking. The lenders to a firm hedge against any risk they take with their money but the stockholders are the real risk takers. All rights of the lenders and of the stockholders and preservation of the balances between their rights and responsibilities are conventionally taken care of in Business Laws. Stocks and bonds are two distinct legal documents with fundamentally different impacts on economic activity. Again, the key to distinguishing money from capital is to bring the institution of the firm into the analysis. To separate money market from capital market on the basis of the duration of the loan period, as is quite often done, is naive.

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The foregoing discussion makes it clear that money is not capital. In summary, money must undergo a legal process in order to become capital, it must inevitably take risk in order to be eligible for profits. This legal process changes the nature of money, making money, now capital, part of an institution. This institution employs other factors co-operating with capital to generate earnings or profit. No return to money/capital is legitimate without this process.

Capital of itself cannot generate profit; it must be incorporated with other factors of production. The same is true with land and/or labour. These three primary factors of production are complements before they can be substitutes. Their interdependencies produce a synergy without which the generation of profit can hardly be imagined. In a fair economic system, as the Islamic economic system claims and aspires to be, profit is to be shared with the other factors co-operating with capital. Such interdependencies, however essential and indispensable, can make it difficult to produce a well defined general equilibrium analysis. However, although difficult, such an analysis is not therefore impossible.

Anything that brings about a money market (intentionally or otherwise), which, in turn, produces interest rates, is to be strictly avoided. Money need not go into such a market in order to become, indirectly, a factor of production. There is a short cut to make this easy, namely to have money go through the aforementioned legal process. Islamic economics, by abolishing interest, clears the fog in one stroke. For those interested in directly financing an investment project, the only safe option is to finance, without interest, as owners of the firm and ask for their share of profits. Such finance can only look to a profit that must originate in the real sector of the economy. This option, which integrates the real and financial sectors of the economy, leaves no room for the money market and its chief pastime, speculation. A firm by definition is, as we have said, a legal entity, which then can transform inputs to outputs. Its legal entity precedes its technicality. Business laws and other related regulations prevent a firm coming into existence before the formalities of the legal processes are concluded. One can rarely find in the literature the legal aspects of how/when money transforms into capital discussed by Western economists, even when this is directly related to the topic in hand (see, Drake, ; Coghlan, ; Tobin, ; Gurley and Shaw, ; and McKinnon, ). In his Capital, Karl Marx addresses ‘the transformation of money and capital’ and gives ‘the general formula for capital’ using exchange cycle of M-C-M’, where M’>M and the increment provides value and surplus value which, according to him (Marx, , Vol. , Pt. , Ch. ), originates from labour power. In such a treatment the main concern is circulating capital, which falls outside the concept we are discussing here. Had there been a satisfactory discussion of the firm as a legal entity, Jean Robinson might not have despaired of the task of answering the question as to the ‘meaning’ of capital rather than its measurement. Case one approaches the problem from an angle different from ours in this paper. Another approach is to consider a firm as a compound, just like natural compounds, made up of wills and wishes and enabled by laws and regulations. The wills and wishes of shareholders enter into a unique entity called the ‘firm’, with a distinct ‘legal personality’, which affects and is affected by the society. The multiplicity of constituents’ (shareholders’) desires and wishes dissolve and transform into the unity of the compound. The common goals of the constituents attain a new form and identity, even though the plurality of shareholders does not convert into a unity — they still preserve other legal and real aspects of their own. The reduction and dissolution of the shareholders’ wills and wishes into the unique legal ‘person’ of the firm is also the cause of the transformation of money into capital. The question is how does that transformation happen and how does it function?

Before presenting our model, we need to make some preliminary remarks, which are simple but have important consequences. We start with a table illustrating factor shares of income conventionally used in textbooks. An amended version of such a table is shown below. The amendment is made on the grounds that interest is return to money, specifically debt, whether used for investment or not. However, in the conventional presentation, interest is return to capital. This has, probably, been one reason why some economists such as Cassel assert that capital produces the interest’. It is not hard to grasp that in reality owners of capital receive profits and owners of money interest.

In this amended table of the distribution of income, money is not only presented as one ‘factor’ of production, in order to make the picture complete, it is also presented at the same level as other factors of production. This is a fallacy. Nowhere in economic theory can one find any legitimate justification for considering money as capital. The proper distinction between money and capital is central to any economic system; it is real and determinant in that the development of an economy is geared to the quantity as well as the quality of capital, not money. No single evidence shows otherwise. The argument presented here, as the amended table indicates, shows that ‘interest’ does not have any place in a coherent and sound economic system and represents what can be called as ‘prime fallacy.’ Interest is, undoubtedly, an artificial social convention, which has been overlaid on money and the universally accepted functions it serves. This becomes clearer still if all the real factors of production, including ‘qualified’ labour, land, and capital, are considered as the wealth of a nation, but money is not —as aptly expressed by Adam Smith.

From the standpoint of accounting principles, any sum of money coming into a firm should be entered under the proper heading — sales, loan, equity-capital, gift, etc. There are many other accounting habits and concepts that economists need to be acquainted with and learn to deploy. A secondary aim of this paper is to reconcile certain terms in economics as closely as possible with those of accounting. Holding the discipline aloof from accounting terms and developing new terms alien to accounting has not brought any real good for economists. To my surprise, economists have developed several terms, different in connotation from accounting counterparts, while at the same time basing their analyses on the statements that accountants produce with the terms commonly used in accounting. Cost and capital are the two obvious ones. In profit and loss statements prepared by accountants, all costs are of historical nature; however, due to the prevalence of inflation all over the world, accountants have taken into consideration this universal disequilibrium phenomenon and have re-assessed some items in the balance sheet and sometimes also a few items in profit and loss statements. Economists emphasize opportunity (or ‘replacement’) costs instead of historical costs. No need to mention that ‘cost’ here has different meanings for accountants and economists. In important cases, economists, unlike accountants, make up terms disconnected from reality. But then, if economists are right to make up their own terms, they should amend their statements according to their terms and produce an ‘economic’ balance sheet, an ‘economic’ profit and loss statement, and the like.

But the evidence is that economists have never attempted to make such amendments but have used the same statements produced by accountants, intact, and made policy recommendations based on these statements. Another important issue is the fact that corporate taxes are based and received on accounting, rather than on economics, principles. Let us ask one of the most important and fundamental questions in this respect: does an economy evolve around accounting or economics principles? Thousands of managers owning their stores ignore the rent that they could have collected if the stores had been rented. They do not customarily add the opportunity cost of their stores on top of other costs and shift it to the customers.

Under certain legal obligations, firms keep records on the basis of accounting rather than economics principles. Artificially and without legal authority to place rules and definitions on firms, which play so important a role in an economy, only takes us away from real world problems. It may even make many of our efforts merely abstract and consequently reduce the other, essential and valuable parts of economics to an academic practice with no relevance to realities. In fact, with the appropriate modifications, nothing is more practical than economics. One way, if not the only way, to make economics more practical than it now is, is to seek some reconciliation between economics and other branches of social science. Not only do we not gain much by isolating some economic concepts from their counterparts in other disciplines but also we lose practicality in these respects. To make economics more sensible than it is now and better understood by students we must strive to bridge the existing gaps between some economics terms and those shared by other related branches of studies such as management, accounting, finance, law, and the like.

A close look at the differences that exist between money and capital shows that they, in fact usually, spring from ideas New Institutional economists have put forward.

Money with all the importance attached to it (i.e., being potential capital besides its fundamental functions in Islamic economics) is discussed differently in other social sciences. Its peculiarity does not make it something that ordinary logic can reject it. If some economists understand money in Table  to be ‘circulating capital’, again it does not give money a character different from capital in accounting language. The origin of some items on the asset side of a balance sheet goes back to the capital initially intended to be put in investment projects. They include cash, bank account, accounts receivable, equipment and machinery, building, storage rooms, inventory… etc. As it stands, economists have to accept all items of the balance sheets prepared by accountants if they take seriously their responsibility for both making economics a practicable science and policy recommendations.

Almost all Western economists believe that capital stands in the same relation to interest as labour does to wages. Besides undermining the place of labour – human beings – they mostly seem to have forgotten where interest has come from. It essentially originates in the money market whose main and ultimate determinant is speculative demand for money – to recall Hicks’ strong assertion that “The demand for money itself is necessarily always speculative in a wide sense” (: ). The money rate of interest is the outcome of speculation on money. Tobin distinguishes two possible sources of liquidity preference (certainly for speculative purposes), while recognizing that they are not mutually exclusive: “The first is inelasticity of expectations of future interest rates. The second is uncertainty about the future of interest rates”.

Some monetary economists have tried to distinguish short-term from long-term interest rates without taking the trouble to go through the details. Nevertheless, the fact is that the long-term is the envelope of the short-term interest rates and that speculative demand for money, which is a short-term phenomenon, determines short-term interest rates. Debt-capital, which is one standard method of financing some or all investment expenditures, is long-term in nature, but it seems borrowers have to borrow at the ‘going’ rate of interest, normally determined in the money market. It is not feasible to talk about two different money markets based on term structure, one for short-term loans, which are basically for speculative purposes and the other for long-term purposes to supply debt-capital. This kind of treatment, if plausible, should be capable of being generalized to cover prices of all durable goods. In reality long-term prices are based on short-term prices; so too, our long-term income depends on our short-term income. This was probably the reason Hicks assumed that one-period interest rates are determined in a general equilibrium framework in which either a long- or a short-term rate, but not both, are included. Additionally, Lutz, in his paper on the term structure, after laying out quite carefully the assumptions needed to validate the expectations hypothesis, concludes that:

(i) The long-term rate is the average of future short-term rates;

(ii) The long-term rate can never fluctuate as widely as the short-term rate;

(iii) It is possible that the long-term rate moves contrariwise to the short term rate.

Although two interest rates are distinguished in capitalism, one short term and the other long-term, they are of the same nature albeit of different magnitudes. The same is true for money; money is money, we do not have different monies. Special care has to be taken here not to confuse our main concern about ‘money’ with other types of money that some economists like Tullock talk about. The type of ‘money’ we are mainly concerned with in this paper is the type that, “in and of itself, is an almost perfect expression of a large externality” (Tullock), whose perfect manifestation is ‘paper money’. We also understand the assertion made by Keynes that for every ‘durable commodity’ there can be a rate of interest in terms of itself, but our focus is on the ‘paper-money rate of interest’.

Now that we have exposed the confusion around the concept of capital and money, a quick review of the rate of interest, as return to money, and rate of profit, as return to capital, and comparison of their impacts on economic activity, should be instructive.


Source: Prof. Iraj Toutounchian, Integrating Money in Capital Theory: A Legal Perspective Towards Islamic Finance. Republished with permission.