Posts Tagged ‘Capital’

The Supply and Demand of Capital

May 23, 2010

This originally started as a comment I made on a blog, and I figured it was worth expanding and posting here.

Overview

All right, get into economic theory thought mode here, because I’m going to be talking about capitalism and supply and demand.

Specifically, the supply and demand of capital itself.

You see, businesses need funding to get started and to expand – this funding is called capital (or ‘venture capital’, for starting some new companies). People with money to spare offer up venture capital, and people who start and run businesses accept it and use it to expand the economy.

Supply for capital is dictated by how much money people have that they don’t need or want to use to consume – these people offer up capital to someone else in exchange for interest on the money they offer up.

Demand for capital is dictated by how much people are consuming – the more people are consuming, the more businesses can expand and the more room for new businesses there are.

Market correction, more supply with less demand

Now, when supply outpaces demand, you end up in a situation where you have people with a whole lot of money, but there’s simply not much to do with it. Businesses that meet all sorts of demand are already well-funded, but people still want to be able to invest capital into them so they can make money.

This makes capital ‘cheaper’ – that is to say, it becomes easier for people running riskier or less profitable businesses to get capital. As supplies of capital continue to increase faster than demand, more and more money is placed in such risky investments.

Eventually, some of the riskier of those investments fail – this reduces the supply of capital, and reverses the trend – now investments that used to be reasonable become too risky to remain invested in, so people start pulling out their money.

But because the value of capital has increased, _nobody_ wants to buy these risky investments, because they are no longer worth the money you’d have to put into them. This means the people who owned those investments must sell them at a fraction of the price, losing much of their wealth and further reducing the supply of capital, which causes the cycle to repeat.

This cycle continues until demand for wealth outstrips supply enough for the economy to start growing again, and in the meantime destroys phenomenal amounts of wealth. This is how a market crash (and subsequent recession/depression) happens.

When the rich become richer, the amount of free capital increases. Conservative economic policies encourage this, and ultimately encourage this kind of market crash.

Market stagnation, more demand with less supply

This is not to say that it’s good for demand to strongly outstrip supply – this makes it harder for people with good ideas to obtain venture capital, as investors of capital have more freedom to ‘shop around’ for higher value, lower risk assets. This means that there will be more economic growth per dollar of capital, yes, and much more stability for that capital, but less total growth.

The market can correct for this situation as well, as people pay more for the limited supply of goods they want, business owners make more profit, which generates capital that can be reinvested towards producing more goods.

This circumstance happens when there are more people demanding goods than there is wealth to facilitate the production of them, generally the result of government policies which reduce profits and improve quality of life for the less wealthy.

Government influence and striking the balance

As this supply/demand relationship among the most expansive that can exist in an economy, government has great ability to influence it incidentally.

Government policies that influence this relationship include but are by no means limited to:

  1. Taxes – progressive taxation systems increase the amount of money that can be spent, which increases demand for capital, and regressive taxation increases the amount of money that goes into supply of capital. The “middle class” is an interesting phenomenon here, as individuals in the middle class both consume, and contribute investment capital – meaning that taxation that discourages the growth of a middle class would probably not significantly affect this relationship, but would reasonably slow an economy nonetheless by reducing both supply of and demand for capital.
  2. Fractional Reserve Banking Policy – Fractional reserve banking is a financial technique where banks get to lend out some of the money they have rather than keep it all in reserve, so long as they keep enough money onhand to be able to manage their activities. This technique increases the supply for capital without capital holders needing to have as much excess wealth to burn, and makes the supply for capital more dynamic and able to respond to a changing economy, but it can be hazardous in the event of a large market crash, as it can cause banks to fail if the market takes too big a hit, too quickly. For this reason, Fractional Reserve policies do not function optimally in environments where supply of capital is naturally abundant compared to demand.
  3. Consumer protection, regulation, etc – The government often uses laws to force businesses to take a stake in their communities, be it through regulation of their practices, regulation over profits vs. reinvestment, minimum wages and labor laws, and so forth. Such regulations, when done properly, generally reduce profits, which decrease capital supplies. Some regulatory measures, such as labor laws, can improve demand for capital by improving worker quality of life.

Government action has a significant amount of influence over the supply and demand of capital through these measures – proper management of these measures can be used to reduce the frequency and severity of market crashes, or to stimulate additional economic growth in the face of high demand for goods.

Sources and forms of capital

Capital doesn’t just come in one flavor. Capital comes from various sources and systems and where it comes from helps to shape the nature of the economy it goes into.

  1. Loans – Loans are a source of capital in which, if the business owner can pay off the loan, the owner then owns the business investment. Fractional reserve banking increases the availability of loans.
  2. Venture capital – Venture capital is a source of capital in which the venture capitalist owns the business investment (or, more frequently, owns a high percentage of it), but grants control of the capital to the individual operating the business. Venture capital is generally intended to ‘cash in’ by selling the company once it has grown, rather than draw profit from the asset.
  3. Public ownership – The company is considered an asset and private individuals or organizations own parts, or hold stock, in the company – an initial release of stock (called an “IPO”) generates capital for the company directly from investors. This stock generally carries with it a degree of control over the company’s operations, and frequently stock corporations are designed to return maximum profit at the demand of stock holders.

Here we can see that different types of capital are facilitated by different sources – the availability of loans, for instance, improves when more assets are placed in banks, and the lucrativeness of public ownership increases when more individuals have wealth to place directly into investment.

Conclusion

Was I supposed to be going somewhere with all that? Well.

An economy thrives best when the supply and demand for capital are balanced, and increasing at the same rate. Excessive supply of capital can be catastrophic to an economy, and excessive demand slows growth.

Indicators of excess supply include booming stock prices and easily-obtainable credit (especially credit used to artificially bolster demand for capital, such as from credit cards). Indicators of excess demand include goods and services shortages.

Generally, a strong supply can be correlated with a more wealthy upper class, and a strong demand can be correlated with a robust lower and middle class and good quality of life.

Conservative policies have led to an extremely wealthy upper class, lower quality of life for the lower and middle classes, and sporadic, catastrophic market crashes. America desperately needs the rich to be less rich, for its’ own health.

Or, in summary, rich people really are bad – at least if there are too many of them, or they’re too rich.