A frame work for analyz ing the rela tions between cash payment commit
ments due to outstand ing liab il it ies and the cash receipts of organ iz a tions with debts is needed if finan cial rela tions are to be fully integ rated into the theory of income and price determ in a tion. Financial instabil ity is a fact and any theory that attempts to explain the aggreg ate beha vior of our economy must explain how it can occur. As finan cial instabil ity is one facet of the serious busi ness cycles of history, a theory that explains finan cial instabil ity will enable us to under stand why our economy is inter mit tently unstable.
Cash payment commit ments on outstand ing instru ments are contrac tual commit ments (1) to pay interest and repay the prin cipal on debts and (2) to pay dividends—if earned—on equity shares. These cash payment commit
ments are money flows set up by the finan cial struc ture. A struc ture of expec ted money receipts under lies the various commit ments to make payments on exist ing debts. Each economic unit—be it a busi ness firm, house hold, finan
cial insti tu tion, or govern ment—is a moneyinmoneyout device. The rela
tion among the various sources and uses of cash for the various classes of economic units determ ines the poten tial for instabil ity of the economy.
Our economy is one that employs complex, expens ive, and longlived capital assets and which has a soph ist ic ated and complex finan cial struc ture.
The funds that are needed to acquire control over the expens ive capital assets of the economy are obtained by a variety of finan cial instru ments such as equity shares, bank loans, bonds, mort gages, leases, and rentals.
Each finan cial instru ment is created by exchan ging “money today” for commit ments to pay “money later.” The payments during any period on outstand ing finan cial instru ments are the “money later” parts of contracts entered into in prior periods. We can summar ize the above by the state ment that firms may and do finance posi tions in capital assets by complex sets of finan cial oblig a tions. The finan cial oblig a tions outstand ing at any date determ ine a series of dated cash payment commit ments.
The legal form that busi ness takes determ ines the debts that can be used to finance owner ship of capital assets. The modern corpor a tion is essen tially a finan cial organ iz a tion. The altern at ives to using corpor a tions as the legal form for private busi ness are sole propri et or ships and part ner ships. In these altern at ives the debts of the organ iz a tion are debts of the indi vidual owner or part ners and the life of the organ iz a tion is limited to the life of the part
ners. As a result of their limited lives and constrained debt carry ing powers, propri et or ships and part ner ships are poor vehicles for owning and oper
at ing longlived and special purpose capital assets. There is a symbi otic rela
tion between the corpor ate form of organ iz ing busi ness and the emer gence of an indus trial and commer cial struc ture in which debt is used to finance the construc tion of and determ ine the control over complex, special purpose and longlived capital assets.
In addi tion to the ordin ary busi ness firms that own the capital assets of our economy there are finan cial firms (banks, etc.) that mainly own finan
cial instru ments. These insti tu tions finance the assets they own (what will be called their posi tion) by some combin a tion of equity (capital and surplus)
www.ebook3000.com
and debts. The typical posi tion of the various types of finan cial insti tu tions will include debts of capital asset owning firms, house holds, govern ments, and other finan cial insti tu tions. In addi tion, some finan cial insti tu tions own equity shares.
Thus there exists a complex network of commit ments to pay money. The units that have entered into these commit ments must have sources of money.
When a finan cial contract is created, both the buyer (lender) and the seller (borrower) have scen arios in mind by which the seller acquires the cash needed to fulfill the terms of the contract. In a typical situ ation there is a primary and some second ary or fallback sources of cash. For example, in an ordin ary home mort gage the primary source of the cash needed to fulfill the contract is the income of the homeowner. The second ary or fall back source of cash is the market value of the mort gaged prop erty. For an ordin ary busi ness loan at a bank, the expec ted differ ence between gross receipts and out of pocket costs is the primary source of cash. Secondary sources would include the value of collat eral, borrow ings, or the proceeds from selling assets. Expected cash receipts are due to contri bu tions to the produc tion and distri bu tion of income, the fulfill ment of contracts, borrow ing and selling assets. In addi tion, payment commit ments can be fulfilled by using what stocks of cash a unit may have on hand.
Our economy there fore is one in which borrow ing and lending on the basis of margins of safety is common place. Today’s payments on outstand ing finan cial instru ments are the result of commit ments that were made in the past—even as today’s trans ac tions create finan cial contracts which commit various organ iz a tions to make payments in the future. The balance sheets at any moment of time of units that make up the economy are “snap shots” of how one facet of the past, the present, and the future are related.
Commercial banks are one set of finan cial insti tu tions in our economy.
Demand depos its, which are part of the money stock, are one of a number of liab il it ies that commer cial banks use to finance their posi tion in finan cial assets. In turn the finan cial assets of banks are debts of other units, which use these debts to finance posi tions in capital assets or finan cial instru ments.
As we peer through the finan cing veil of the inter re lated set of balance sheets, it becomes evident that the money supply of the economy is like a bond, in that it finances posi tions in capital assets. Before one can speak securely of how changes in the money supply affect economic activ ity, it is neces sary to penet rate the finan cing veil to determ ine how changes in the money supply affect the activ it ies that are carried out.
Each finan cing trans ac tion involves an exchange of money today for money later. The parties to the trans ac tion have some expect a tions of the uses to which the receiver of money today will put the funds and how this receiver will gather the funds by which to fulfill the moneytomorrow part of the bargain. In this deal, the use by the borrower of the funds is known with a consid er able assur ance; the future cash receipts which will enable the borrower to fulfill the moneytomorrow parts of the contract are condi
tional upon the perform ance of the economy over a longer or shorter period. Underlying all finan cing contracts is an exchange of certainty for uncer tainty. The current holder of money gives up a certain command over current income for an uncer tain future stream of money.
Just as there is no such thing as a free lunch, there is no such thing as a certain deal involving the future. Every invest ment in capital assets involves giving up some thing certain in exchange for some thing conjec tural in the future. In partic u lar, any set of capital assets acquired by a firm is expec ted to yield cash flows over time whose sum exceeds by some margin the cash paid for the capital asset. These expect a tions are, however, condi tional upon the state of partic u lar markets and of the economy in the various futures in which cash receipts are to be collec ted. In making moneytoday–money
tomorrow trans ac tions, whether the trans ac tion be a finan cial trans ac tion, such as issuing or buying bonds, or an invest ment trans ac tion, in which current resources are used to create capital assets, assump tions about the intrins ic ally uncer tain future are made. The assump tions often are that the intrins ic ally uncer tain future can be repres en ted by a prob ab il ity distri bu
tion of, say, profits, where the prob ab il ity distri bu tion is assumed to be like the prob ab il ity distri bu tions that are used to repres ent outcomes at a rou lette table. However, the know ledge of the process that determ ines the prob
ab il it ies is much less secure for economic life than it is for fair roul ette wheels. Unforeseen and unlikely events occur in gambling games and in economic life. Unlikely events will not cause a radical change in the esti mates of the frequency distri bu tion of outcomes at the roul ette table whereas they are quite likely to cause marked change in the expect a tion of the future that guides economic activ ity.
The finan cial struc ture of our economy can be viewed as appor tion ing among various units the poten tial gains and losses from various under tak
ings in which the outcome is uncer tain. By the very nature of uncer tainty, the actual results are quite likely to deviate markedly from anti cip ated results.
Such devi ations will lead to capital gains and losses. Experience with capital
gains and losses will lead to changes in the terms upon which a certain command over resources will be exchanged for a conjec tural future command over resources. The prices of capital assets and finan cial instru
ments will change as history affects views about the like li hood of various outcomes.
Households, busi nesses, govern ment units, and various types of finan cial insti tu tions issue finan cial liab il it ies. Each issuer of finan cial instru ments has a main source of cash which is expec ted to accrue so that the finan cial instru ments it has outstand ing can be valid ated. The primary source of cash for house holds is wages, for busi ness firms it is gross profits, for govern
ment units it is taxes, and for finan cial insti tu tions it is the cash flow from owned contracts. In addi tion each unit can, in prin ciple, acquire cash by selling assets or by borrow ing. Although the normal economic activ ity of many units depends upon borrow ing or selling assets to obtain cash we will consider such finan cial trans ac tions as a second ary source of cash—where the term second ary does not neces sar ily carry any pejor at ive connota tions.
Household wage income, busi ness profit flows, and govern ment tax receipts are related to the perform ance of the economy. The primary cash flows that valid ate house hold, busi ness, and govern ment debts depend upon the level and distri bu tion of nominal income. In our type of economy one link between finan cial markets on the one hand and income and output produc tion on the other is that some of the demand for current output is financed by the issu ance of finan cial instru ments, and a second is that wage, profit, and tax flows need to be at a certain level to meet a stand ard that is determ ined by the payment commit ments on finan cial instru ments if finan
cial asset prices and the ability to issue finan cial instru ments are to be sustained. A capit al ist economy is an integ rated finan cial and produc tion system and the perform ance of the economy depends upon the satis fac tion of finan cial as well as income produc tion criteria.
Iv. HEDGE, SPEC U LAT IvE, AND PONzI FINANCE
Three finan cial postures for firms, house holds, and govern ment units can be differ en ti ated by the rela tion between the contrac tual payment commit
ments due to their liab il it ies and their primary cash flows. These finan cial postures are hedge, spec u lat ive, and “Ponzi.” The stabil ity of an economy’s finan cial struc ture depends upon the mix of finan cial postures. For any given regime of finan cial insti tu tions and govern ment inter ven tions the
greater the weight of hedge finan cing in the economy the greater the stabil ity of the economy whereas an increas ing weight of spec u lat ive and Ponzi finan cing indic ates an increas ing suscept ib il ity of the economy to finan cial instabil ity.
For hedge finan cing units, the cash flows from parti cip a tion in income produc tion are expec ted to exceed the contrac tual payments on outstand ing debts in every period. For spec u lat ive finan cing units, the total expec ted cash flows from parti cip a tion in income produc tion when totaled over the fore see able future exceed the total cash payments on outstand ing debt, but the near term payment commit ments exceed the near term cash flows from parti cip a tion in income produc tion, even though the net income portion of the near term cash flows, as meas ured by accep ted account ing proced ures, exceeds the near term interest payments on debt. A Ponzi finance unit is a spec u lat ive finan cing unit for which the income compon ent of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstand ing debt will grow due to interest on exist ing debt. Both spec u lat ive and Ponzi units can fulfill their payment commit ments on debts only by borrow ing (or dispos ing of assets). The amount that a spec u lat ive unit needs to borrow is smaller than the matur ing debt whereas a Ponzi unit must increase its outstand ing debts. As a Ponzi unit’s total expec ted cash receipts must exceed its total payment commit
ments for finan cing to be avail able, viab il ity of a repres ent at ive Ponzi unit often depends upon the expect a tion that some assets will be sold at a high enough price some time in the future.
We will first examine the cash flow, present value, and balance sheet implic a tions of hedge, spec u lat ive, and Ponzi finan cial postures for busi ness firms. The finan cing of invest ment and posi tions in capital assets by debts is a distin guish ing attrib ute of our type of economy. This makes the cash flows and balance sheets of busi ness of special import ance. As our focus is upon the payment commit ments due to busi ness debts, the cash receipts of special interest are the gross profits net of taxes but inclus ive of interest payments, for this is the cash flow that is avail able to fulfill payment commit ments. The gener a tion and distri bu tion of this broad concept of profits is the central determ in ant of the stabil ity of an economy in which debts are used to finance invest ment and posi tions in capital assets.
The valid a tion through cash flows of the liab il it ies of house holds and govern ments is of great import ance to the oper a tion of today’s capit al ist econom ies. Household and govern ment finan cing rela tions affect the
stabil ity of the economy and the course through time of output, employ
ment, and prices. However, the essen tial cyclical path of capit al ist econom ies was evident when house hold debts were small and govern ment, aside from times of war, was small. Household and govern ment debt creation and valid a tion modify but do not cause the cyclical beha vior of capit al ist econom ies. It will be evident in what follows that if the debt gener a tion and valid a tion by govern ment becomes large relat ive to the debt gener a tion and valid a tion by busi ness the basic path of the economy is likely to be affected.
Business firms
The funda mental vari ables in analyz ing the finan cial struc ture of busi ness firms are the cash receipts and payments of economic units over a relev ant time period. The total receipts of a busi ness firm can be divided into the payments for current labor and purchased inputs and a resid ual, gross capital income,3 that is avail able to pay income taxes, the prin cipal and interest on debts and for use by the owners.
We there fore have:
Gross Capital Income = Total Receipts From Operations − Current Labor and Material Costs
and
Gross Capital Income = Principal and Interest Due on Debts + Income Taxes + Owners “Income.”
In terms of the data avail able in National Income and Flow of Funds accounts, gross capital income equals gross profits before taxes plus interest paid on busi ness debts. In analyz ing the viab il ity of a finan cial struc ture and the constraints it imposes, gross capital income as here defined is the key receipts vari able.
The cash payments made by a unit over a relev ant time period equal the spend ing on current labor and purchased inputs, tax payments, the remit
tance due to debts that fall due, and dividends. Over any partic u lar inter val cash payments may exceed, equal, or fall short of cash receipts. Of the payments the crit ical items are current input costs, taxes, and payments required by outstand ing debts. As current costs and taxes are subtrac ted from