The Great Debate©: Public Banking

Debate between Ellen Brown and Michael Rozeff

Editor’s note: This debate started with an article by Ellen Brown (first article below) which elicited a response from Michael Rozeff (second article below) and then a rebuttal from Brown.  Prof. Rozeff has made available further points after this debate was published, available in Some Further Thoughts on Ellen Brown’s Reply.

Time for an Economic Bill of Rights

by Guest Author Ellen Brown, Web of Debt

Henry Ford said, “It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

We are beginning to understand, and Occupy Wall Street looks like the beginning of the revolution.

We are beginning to understand that our money is created, not by the government, but by banks.  Many authorities have confirmed this, including the Federal Reserve itself.  The only money the government creates today are coins, which compose less than one ten-thousandth of the money supply.  Federal Reserve Notes, or dollar bills, are issued by Federal Reserve Banks, all twelve of which are owned by the private banks in their district.  Most of our money comes into circulation as bank loans, and it comes with an interest charge attached.

According to Margrit Kennedy, a German researcher who has studied this issue extensively, interest now composes 40% of the cost of everything we buy.  We don’t see it on the sales slips, but interest is exacted at every stage of production.  Suppliers need to take out loans to pay for labor and materials, before they have a product to sell.

Continue reading…..

The Many Fallacies of Ellen Brown

by Michael Rozeff, Lew Rockwell.com

Ellen Brown, who is an attorney, has written an article about what she calls “An Economic Bill of Rights”. I will argue that her case is totally wrong. It is totally permeated with factual and conceptual errors.

Even without my showing precisely how her financial analysis is in error, we can understand that she is propounding nonsense by looking at her pie-in-the-sky conclusion:

“If the government owned the banks, it could keep the interest and get these projects at half price. That means governments – state and federal – could double the number of projects they could afford, without costing the taxpayers a single penny more than we are paying now.

“This opens up exciting possibilities. Federal and state governments could fund all sorts of things we think we can’t afford now, simply by owning their own banks.”

Brown wants government to double in size. That would make it 80 percent of the economy. This is nonsense. It is an impossibility. If government becomes 80 percent of the economy, the economy will shrink drastically because productivity will plummet. Not only that, huge amounts of capital will flee the country.

Brown thinks that this expansion can be done costlessly. That is, she thinks that the resources absorbed by government are costless. This is patently false. All resources diverted to government are taken away from persons who would otherwise use them for their own purposes. The diversion removes the opportunities for private use. Hence the cost of the diversion to government is, at a minimum, the opportunity cost of those resources or capital. And that’s a minimum cost because it excludes the costs the government incurs in seizing the resources and the costs incurred in misallocating those resources after they are seized.

Brown doesn’t understand the effects of government on private economic behavior. She doesn’t understand government’s inefficiency and incapacity to be productive. She doesn’t understand cost, that is, opportunity cost.

Brown thinks that there is a governmental free lunch. She thinks she has discovered a free lunch that has up to now eluded realization and perhaps discovery by the human race. She seems not to realize that the Russian and Chinese Communists did what she is proposing. They absorbed all the banks. They mobilized all the capital they could lay their hands on. They funded all sorts of things. The costs of seizing this capital were enormous. Millions of people were killed, imprisoned, and sent to gulags. Millions were impoverished. Misery mushroomed. The results were total failure.

The difficulty in rebutting what she says is that her message has been reduced to a simple catchy theme. It is a false theme, but it still has the power to attract. Her theme appeals to anti-banker sentiments. It appeals to anti-interest sentiments. She asserts that the prices we pay for goods are 40 percent interest costs. This catches one’s attention, but it is total nonsense. It is totally wrong. It is outrageously high and exaggerated.

She goes on to assert that this cost, whatever size it is, magically disappears if government owns the banks. This is also entirely wrong. If a government company builds a car, the capital it obtains in order to begin production has, all else equal, the same cost as if Toyota were to obtain that capital. Capital costs do not disappear because production is socialized in the realm of government ownership. Capital still remains scarce.

Furthermore, Brown exaggerates the amount of capital supplied by banks. Somewhere around 60 percent of debt capital is supplied to businesses by the direct purchase of debt instruments in capital markets (estimated using the flow of funds accounts). Banks don’t supply much long-term debt to businesses. Since debt is about 1/3 of overall capital and the rest is equity, banks supply about 0.4 x 0.33 = 13.2 percent of all capital to businesses. These are rough figures, but refinements won’t change the overall conclusion. Even if Brown’s nirvana of socializing or nationalizing banks were brought into being, it wouldn’t touch the vast majority of capital that is directly supplied to companies.

I will now argue that her 40 percent figure is vastly overstated. To do that, we will take an excursion through the basic finance of which Brown is apparently ignorant.

What is capital? Capital consists of all goods that people intend to use for activities that are intended to satisfy future wants, as opposed to consumer’s goods that are used to satisfy immediate wants. Capital is measured in terms of a money unit of account.

Businesses that produce goods for future consumption use capital in their processes of production. This capital is scarce, which means it is definitely not free or costless. There is competition to obtain capital. There are markets for it called capital markets. There is supply of capital and there is demand, and their activity produces a cost of capital that is positive or above zero. If the price or cost of capital were zero, the demand for it would vastly exceed the supply.

All capital has a cost, which is in fact called the “cost of capital”. This cost doesn’t vanish if a business owner supplies his own capital to his own business. A person who uses his own capital in his business loses the opportunity of supplying it to others at the market price. He loses income that he could have gotten by allowing others to use his capital. This person has an opportunity cost of capital. If he makes a rational calculation and accounting, he should demand of his business that it pay back to him this implicit cost of capital that he has diverted away from an external market and used instead for his own business purposes. What he has given up by not placing his capital in an external market he should at least recover by using it for his own purposes. He should, in essence, pay himself for the use of his own capital.

The cost of capital doesn’t vanish if a government takes capital from its citizens and uses it for government activities or government-owned businesses. If we think of the government as a kind of organization owned by citizens, then, in the employment of capital by the government, the citizens are analogous to a business owner that employs his own capital in his business. That is, there is still a cost of capital used by the government when citizens supply their capital or are forced to supply it to the government. They lose the opportunity of deploying this capital elsewhere in productive enterprises, and that loss measures the cost to them of government’s absorption of the capital.

In other words, no magical gain occurs when government absorbs and deploys the capital that it extracts from citizens. The basic reason that no gain occurs is that capital is scarce, which means it has a cost. That cost doesn’t vanish as capital is shifted from one owner to another, including government ownership.

Brown fails to recognize this basic fact. She wrongly thinks that if government keeps the interest that it gets its projects at half price. All that happens, however, is that government recovers the cost of capital for itself. The projects don’t cost any less at all. Her error is like thinking that a man who uses his own $3,000 to build a motorcycle can build it at half the cost of someone who borrows the $3,000 from a bank to build it. Obviously the costs of the materials, labor, and so on are the same. The cost of the capital is less obviously present. With bank borrowing, the man pays interest. Let us suppose that it’s at 6 percent for one year, so he pays $180. The man who uses his own $3,000 loses the opportunity to invest his funds externally. If he can invest at 6 percent, he loses $180. This is a real cost to him of using his own funds. There is a finance cost regardless of whether the bank funds the project or the man funds the project himself.

All users or demanders of capital bear the cost of capital. They pay it to capital suppliers to induce them to save, that is, to forego consuming their resources and instead to invest them. The cost of capital also includes payment for the risks that savers bear when they transfer their capital to the users of capital.

Next, I expose the absurdity of her 40 percent number.

How large are capital costs? A significant company might have 1/3 debt and 2/3 equity capital. The cost of debt might be 6 percent. The cost of equity might be 9 percent. The weighted average cost, excluding tax effects, is then 8 percent (1/3 x 6 + 2/3 x 9). These numbers are made up, but they give a reasonable idea of overall capital cost. I will use that 8 percent figure below.

A company employs capital and it has a balance sheet. On one side, the left hand side, are the assets employed in the business. The left side provides measures in money terms of the assets that the business managers have decided to employ in the business in their production processes, such as buildings, a cash account, inventories, vehicles, computers, etc. The left side assets are capital in forms thought to be productive. On the other side of the balance sheet, the right hand side, are the liabilities (debts) and equity (or ownership) capital that finance the business. It shows capital in the form that capital-suppliers have agreed to make available to the business. The balance sheet always balances. The money valuation of the left side assets equals the money valuation of the right side liabilities and equity capital. We may use either total to measure the total capital deployed in the business.

We see that the total capital employed in the business is measured in book value (accounting) terms by either all the assets on the one side or all the capital (debts + equity) on the other.

Let’s do a hypothetical example in which we use the cost of capital as 8 percent. Suppose the company has $100 of assets. Then it has $100 of capital in the business. These assets have to earn $8 in order to cover capital costs of one year. Suppose that the business has sales revenues of $150 during the year. The revenue is not business profit. Much of this revenue will be absorbed by operating costs, such as payments for labor services, payments for energy, payments for goods purchased from other companies, payments for transportation, payments for advertising, payments for distributions, etc. One of the costs is the cost of capital. On income statements that calculate business profits, the costs of debt are explicitly accounted for by interest costs. The costs of equity capital are not explicitly accounted for, but they are still real. It is a mistake to overlook them.

Business managers attempt to lower their costs so as to produce greater profits. They will attempt to obtain capital to finance the business at the lowest cost they can, all else equal. They might conceivably measure their capital cost as a fraction of their sales revenues. This ratio is not one that is ordinarily calculated in doing a financial analysis. This is the ratio that Ellen Brown cites and relies upon as being about 40 to 50 percent.

In our example, the ratio is $8/$150 = 5.33 percent. The estimate of 40-50 percent intuitively seems way too high, and it is way too high. It means that on a complete income statement of this company the capital costs are $60 to $75. Suppose we use the 40 percent number or $60 of capital costs. Suppose that debt costs are 6 percent. With debt as 1/3 of capital, that means that debt costs are 0.06 x $33.33 = $2. That leaves $58 for the equity costs. The equity costs are $58/$66.67 = 87 percent. This is outlandishly high. It is caused by Brown’s outlandishly high estimate of 40 percent capital costs. Actual equity costs in the real world are nowhere near 87 percent. They range from 8 to 15 percent for many established corporations. They run higher than that for more risky enterprises, perhaps 15 to 25 percent. They don’t run 87 percent for businesses with reasonable prospects.

What would be more reasonable? In my example, if $8 are capital costs and if $2 of this is for debt, then the remaining $6 is for equity. The equity cost is then $6/$66.67 = 9 percent. That is more reasonable. Very long run returns on common stock equity are near this number. Long run returns on the accounting value of equity may run somewhat higher, more like 10-12 percent. That still comes nowhere close to a number that justifies the assertion that capital costs are 40-50 percent of the selling price of goods, and that is what Ellen Brown asserts:

“According to Margrit Kennedy, a German researcher who has studied this issue extensively, interest now composes 40% of the cost of everything we buy. We don’t see it on the sales slips, but interest is exacted at every stage of production. Suppliers need to take out loans to pay for labor and materials, before they have a product to sell.”

Brown’s bottom line proposal is that the government create money instead of the banking system. She wants the government to set up its own banks. She says that this would bypass “the interest tab”. We have seen that this doesn’t bypass the cost of capital at all, not when that capital comprises real resources and the government absorbs these resources. But Brown has another fallacy in mind which is that fiat currency will eliminate the capital cost. She wants the government banks to issue fiat currency which is non-interest bearing and in this way fund projects at what she thinks is a zero capital cost.

Picture a government printing press for currency. Citizens are required to accept the newly-printed paper in payments for goods. Obama’s lieutenants take the paper currency and spend it for their favorite projects. All this amounts to is a different kind of taxation scheme by which the government absorbs (seizes) resources that are in limited supply. The opportunity costs of these seized resources still do not vanish no matter whether the resources are seized directly, taxed through the IRS, or obtained by spending new pieces of green paper.

Brown is committing the same fallacy as the Communists who attempted in vain to get rid of interest. It is an impossibility. The interest measures the postponement of consumption and arises because of it. If there are to be any production processes, they require capital and non-consumption. There will have to be interest. If interest is forcibly suppressed, capital will flee and people will engage in greater consumption. Capital will be consumed and the economy will go downhill. Government printing presses amount to taxes on capital. They will have the same results.

There is much that is wrong with our monetary system. There are a good many critics of it who are offering sound criticisms and sound recommendations for improving it. Ellen Brown is not among them.

Response to Michael Rozeff, “The Many Fallacies of Ellen Brown”

By Ellen Brown

Michael Rozeff has just posted a piece on LewRockwell.com called “The Many Fallacies of Ellen Brown,” responding to my article titled “Time for an Economic Bill of Rights”. Here is a short reply.

Mr. Rozeff seems to think that (1) saving the government money is a bad idea, and (2) keeping the status quo, in which private bankers get the inflated cost of money — a cost that is passed on to the consumer — is a good idea. If he actually believes that, one has to wonder at his competence; and if he doesn’t, one has to wonder at his motives and whom he represents. The post is an appeal to emotion and fear, and mischaracterizes what I said.

The point of my article is that the interest paid by the government could be returned to the government, if the government owned the bank. The government could then spend this money into the economy or reduce taxes by that amount. How this would make government 80% of the economy or turn it communist, as claimed by Mr. Rozeff, is not clear. Forty percent of the German banking sector is publicly-owned. Has this made Germany a communist country? No. The German economy is the most robust and productive in the EU, and it remains capitalist. The public banks service the small and medium-sized privately-owned businesses that are the productive strength of the economy. See my earlier article here. Similarly in Canada: it borrowed from its own central bank effectively interest free until 1974, and accomplished remarkable things with this government-issued capital expenditure, including funding its health care system.

On Margrit Kennedy’s figure of 40% for interest paid on household debt, see her graphs posted here.

The problem with the monetary scheme today is the skyrocketing inequality of wealth, which is mathematically unsustainable; and this gross inequality is caused by the private ownership of credit. “Them that has, gets.” They are the few at the top, the 10% who collect the interest paid by everyone else. A major point made by Margrit Kennedy is that interest is a huge regressive tax, overwhelmingly paid by the bottom 80% who can least afford it, overwhelmingly enjoyed by the uppermost 10%, rigging society with a huge wealth transfer in the wrong direction.

A prevailing economic fallacy is that the total debt borne by the people is unimportant, because it is a zero-sum game: “we owe it to ourselves.” This would be true if “we” and “ourselves” were the same entities, but under the current scheme, they are not. As if everyone in France being in debt to Marie Antoinette would make no difference no matter how high the total debt, even if interest extracted from the average Frenchman for payment to Marie Antoinette climbed so high they could no longer feed themselves, because after all, it is just money owed within France, and one person’s liability is another person’s asset.

The current banking system is unsustainable because the populace does not have enough money left over after paying interest and other costs to purchase the nation’s GDP. Production of GDP therefore drops due to insufficient demand, in a descending spiral called “recession” or “depression.” If the interest is returned to the public, the system becomes sustainable.

“Finance capitalism” is the antithesis of real, industrial capitalism. It is a parasite on industrial capitalism, destroying it from within. As economist Michael Hudson writes:

“To save society, its victims must see that asset-price inflation fueled by debt leveraging makes them poorer, not richer, and that financialization is the destroyer and exploiter of industrial capital as well as of labor.”

Friedrich Hayek, one of the patron saints of Lew Rockwell Libertarianism, wrote in The Road to Serfdom that one price of freedom that needs to be accepted is that it leads inevitably to economic inequality.  He cited the then-prevailing salary of a CEO, which was about 30 times the salary of the lowest paid worker. That was in 1944.   Today the salary of Bank of America’s CEO is over 400 times larger than that of a beginning teller.  Would Hayek think that that disparity was acceptable?  Would he think the multiple should be allowed to grow without limit?  And even if he would, CAN it keep growing without limit?

When the parasite runs out of its food source, it must and will perish. When that happens, we need to be ready with something new and improved.   Better yet, we need to be ready before it happens – or we may find ourselves with a “new” one-world currency and a “new” one-world government.

Related Article

Some Further Thoughts on Ellen Brown’s Reply by Michael Rozeff

About The Authors

Ellen Brown developed her research skills as an attorney practicing civil litigation in Los Angeles. She’s the author of Web of Debt, the book, and blogs at Web of Debt.  She is Chairman and President of the Public Banking Institute.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire: Liberty vs. Domination and the free e-book The U.S. Constitution and Money: Corruption and Decline.  He blogs at Lew Rockwell.com where you can read The Best of Michael S. Rozeff.

3 replies on “The Great Debate©: Public Banking”

  1. There are so many errors in Rozeff’s critique that basically his entire argument is one long journey through monetary confusion. I will start by identifying his theoretical errors and then proceed to show where he specifically applies these errors in his critique of Ellen.
    Rozeff doesn’t understand, and therefore fails to engage, Ellen’s basic argument, which is that the monetary cost of government borrowing money to finance capital expenditure is DOUBLED (on average) by interest payments to private sector lenders, and that government (and the taxpayers who ultimately pay the interest) can save itself the interest expense by opening a public bank and lending the money to itself, then refunding the interest charges to itself, creating effectively interest free loans, and thereby saving taxpayers fully one half of the money cost of the capital goods.
    This is a “monetary” mechanism to reduce a money cost, but Rozeff makes a long argument about the cost of “real capital”, as if real capital (labor and all other economic resources) and financial capital (money) are one and the same thing. They are not. Money and the real economy are two entirely separate systems. Financial capital and real capital are two entirely different kinds of things.
    The real economy produces exactly zero “money” (except counterfeiters). It produces economic goods and services. The money system produces exactly zero “economic value”: it creates and allocates money numbers. How do these two disparate systems interact so that the economy has money to use?
    The essence of Rozeff’s error is the common feature of all such error that we find in the classical, neoclassical and Austrian schools of thinking. They conflate goods-values with money, and they vacillate between the two uses as if goods and money are one and the same thing.
    The foundation of this error is assuming in the first place that we are essentially living in a barter economy where everybody produces goods values and we exchange those values with one another, often via the medium of money, and money is just another commodity of flexible value like all other goods that people exchange in the marketplace. The fallacy arises from failing to recognize that money is something “real”. Unlike gold, fiat money is simply numbers in banking system computers (purely numerical bank deposits are exchangeable for ‘physical’ banknotes), but even though money is just numbers it still is not merely some numerical “representation”, with economic goods being the “real” thing exchanged. Money, whether in the form of purely numerical bank deposits that can be transferred by check or debit, or in the form of banknotes (“cash”; soft currency), or in the form of a commodity like gold (hard currency), is the entire demand side of the supply-demand equation.
    In fact we live in a money economy, not a barter economy. We do not “exchange goods values” in the marketplace. We “buy and sell stuff”. This next point is critical so I will shout it: THE DEMAND SIDE OF VIRTUALLY EVERY ECONOMIC EXCHANGE IN THE REAL WORLD MARKETPLACE IS MONEY. Demand is not ‘represented by’ or ‘denominated in’ money. Demand IS money. Everybody “wants” economic goods, so there is always real demand for goods. But there is not always “effective demand” for goods.
    Effective demand is money in the hands of people who want to buy stuff. The stuff can be consumer goods that will be used up by the buyer or it can be capital goods that will be worked by the buyer to generate more economic value. Either way, whether the money is spent as consumption or investment, the critical fact is that no consumption or investment can take place without the SPENDING of MONEY.
    Where does money come from and how does it get into the hands of people who want to buy stuff? I.e., how does money become effective demand for consumer and investment goods?
    Classical, neoclassical and Austrian economics never answer this question, and they don’t think they have to, because they simply “assume” the money. They follow Jean-Baptiste Say, “Supply creates its own demand.”
    In a barter economy if I produce tin pails and if there is always a demand for tin pails because our economy is always in a state of scarcity, then by producing the pails I have produced “exchange value” that I can haul to the marketplace and use to “purchase” a side of pork or whatever else I “demand”. My production of a “supply” of economic goods automatically provides me with effective “demand” for goods produced by others. “Supply creates its own demand.”
    But this only works in a barter economy under conditions of permanent economic scarcity where more goods of practically any kind are always wanted by people.
    In the real world we have businesses who do nothing but load perfectly good and almost new furnishings and other real economic goods out of foreclosed McMansions and haul that stuff to the dump where it is crushed by bulldozers because THERE IS NO EFFECTIVE DEMAND FOR THOSE GOODS. The people who want those goods are “bankrupt”: they have no money to pay for the goods they want, so they are kicked out of their house and their goods are hauled to the dump. Our real world economy violates the conditions under which Say’s Law applies. We do not suffer economic scarcity. We live in economic abundance, luxuriously, extravagantly, wastefully so.
    And with labor specialization almost nobody directly produces anything of exchangeable value. Farmers who sell food in farmers’ markets are an exception, as are service providers like welders and mechanics who fix stuff. Most people work in offices (try selling the pieces of paper with writing on them, that you produce in the office, out in “the free market”: the “exchange value” of that “production” is effectively $zero outside your office) and retail where no real economic wealth at all is directly produced; or they work in complex industries where any individual only contributes a narrow (and in itself unmarketable) component of what will ultimately be the product that is sold, like steel or oil or a car.
    By digging a hole in the ground you produce a hole. Nobody is going to buy that hole from you. It has no exchange value. But pumping crude oil out of that hole and refining it into gasoline will ultimately generate a marketable commodity, gasoline, which itself is only in demand if internal combustion engines also exist, AND if the people who want to use those engines to power machines have money to buy the gasoline. We are so far removed from any semblance of bartering exchange values in a marketplace that the idea would be laughable if it weren’t for the woeful fact that it is accepted as “reality” by classical, neoclassical and Austrian schools of economics. As I will demonstrate by pointing out instances in Rozeff’s arguments below. My comments will be in {brackets}.

    The Many Fallacies of Ellen Brown
    by Michael Rozeff, Lew Rockwell.com
    Ellen Brown, who is an attorney, has written an article about what she calls “An Economic Bill of Rights”. I will argue that her case is totally wrong. It is totally permeated with factual and conceptual errors.
    Even without my showing precisely how her financial analysis is in error {i.e. my perspective is “intuitively obvious” so I don’t need to engage her arguments logically}, we can understand that she is propounding nonsense by looking at her pie-in-the-sky conclusion:
    “If the government owned the banks, it could keep the interest and get these projects at half price. That means governments – state and federal – could double the number of projects they could afford, without costing the taxpayers a single penny more than we are paying now.
    “This opens up exciting possibilities. Federal and state governments could fund all sorts of things we think we can’t afford now, simply by owning their own banks.”
    Brown wants government to double in size {the chain of logic eludes me, but if Rozeff is saying that government doubling its capital projects doubles government per se, then he is wrongly assuming that capital projects comprise 100% of government activity}. That would make it 80 percent of the economy {federal taxes are currently 18% of GDP, and the deficit is about 10% of GDP, so federal government is currently 28% of the economy, not 40% as Rozeff’s arithmetic suggests; add State and local government and 40% might be accurate, but here again, capital projects are a minor component of government activity so doubling the projects does not double the government}. This is nonsense. It is an impossibility. If government becomes 80 percent of the economy, the economy will shrink drastically because productivity will plummet {the assumption is made without proof that government is unconditionally inefficient and that the private sector is unconditionally more efficient}. Not only that, huge amounts of capital will flee the country {that horse is long gone: huge amounts of capital have already flown to Asia and elsewhere over the past 30 years of corporate globalization}.
    Brown thinks that this expansion can be done costlessly. That is, she thinks that the resources absorbed by government are costless. This is patently false. All resources diverted to government are taken away from persons who would otherwise use them for their own purposes {this is true if and only if the economy is already running at full capacity. When the economy is slack, such as in a recession/depression, NOBODY is using the idle resources, nor does anybody who has money want to put them to work, because depression is a lack of effective demand and you can’t recover the costs of your investments under these circumstances let alone make profits}. The diversion removes the opportunities for private use. Hence the cost of the diversion to government is, at a minimum, the opportunity cost of those resources or capital {in a depression the opportunity cost of using idle resources IS NEGATIVE; that is, there is positive net economic benefit from putting those resources to work rather than letting them lie idle}. And that’s a minimum cost because it excludes the costs the government incurs in seizing the resources and the costs incurred in misallocating those resources after they are seized (gee, only government misallocates? How about several trillion dollars worth of McMansions whose construction was financed by money-creating PRIVATE SECTOR bankers? Was there a wee bit of financial misallocation here that caused a wee bit of real resource misallocation, as in building millions of houses that NOBODY IN AMERICA CAN AFFORD TO BUY AT THEIR COST PRICE?}.
    Brown doesn’t understand the effects of government on private economic behavior (am I hearing the confidence fairy?}. She doesn’t understand government’s inefficiency and incapacity to be productive { a ridiculous generalization – government bureaucrats are worthless slackers; corporate bureaucrats are value generating paragons; Rozeff specializes in mistaking the slogans and truisms of anti-government propagana as “facts”}. She doesn’t understand cost, that is, opportunity cost {Rozeff doesn’t understand economics, idle capacity economics}.
    Brown thinks that there is a governmental free lunch. She thinks she has discovered a free lunch that has up to now eluded realization and perhaps discovery by the human race {recently Dirk Ehnts has been digging up centuries old expressions of these ‘discoveries’; e.g. Thomas Malthus’ description of the fallacy of composition of “savings”; during the last depression 80-90 years ago Irving Fisher and CH Douglas wrote extensively about their ‘discoveries’; more recently Hyman Minsky built on those ‘discoveries’; what is “news” to Mr. Rozeff is ancient history to anybody who have done any research into the history of thinking about money and macroeconomics; apparently only private sector bankers who create money as loans at interest deserve a “free lunch” in Rozeff’s universe}. She seems not to realize that the Russian and Chinese Communists did what she is proposing. They absorbed all the banks. They mobilized all the capital they could lay their hands on. They funded all sorts of things. The costs of seizing this capital were enormous {apparently Mr. Rozeff is unaware of developments in China since Deng Xiopang declared in 1988, “to be rich is glorious”; the Chinese government owns the Chinese money system and the banks, and China “funds all kinds of things”, like high speed rail, massive industrial capacity, etc. I am failing to see the “enormous costs” of “seizing this capital”; what I see looks very much like enormous benefits to the Chinese economy and people}. Millions of people were killed, imprisoned, and sent to gulags. Millions were impoverished. Misery mushroomed. The results were total failure {Rozeff’s point here is valid: excessive centralized control of a large scale economy like China or Russia rarely generates optimal outcomes; just look at the uniform herd behavior of US and European bankers during the 2000s RE bubble, which popped, and “millions were impoverished. Misery mushroomed. The results were total failure.”; excessive allocation power is the culprit, whether the concentrated allocation power is wielded by government managers or private managers called “bankers”}.
    The difficulty in rebutting what she says is that her message has been reduced to a simple catchy theme. It is a false theme, but it still has the power to attract. Her theme appeals to anti-banker sentiments {pretty hard to find any pro-banker sentiment among the still bleeding OECD victims of recent bankster kleptocracy}. It appeals to anti-interest sentiments {classical economics was all about freeing the productive factors from economic rents, like interest payments; so is Rozeff disparaging Smith, Ricardo and Mill along with Ellen Brown?}. She asserts that the prices we pay for goods are 40 percent interest costs. This catches one’s attention, but it is total nonsense. It is totally wrong. It is outrageously high and exaggerated {if this is exaggerated, then how can it be that finance is capturing 40% of ALL corporate profits? 50% of the total price paid for mortgaged gov’t capital projects and mortgaged private and commercial real estate is interest that is paid year by year over the amortization of the debt; RE and other capital spending do not comprise 80% of all spending, so the 50% interest component of RE and capital costs does not by itself produce the 40% interest total in all prices; but RE is by far the largest asset class in every economy, so it’s no stretch that 40% of all prices is interest}.
    She goes on to assert that this cost, whatever size it is, magically disappears if government owns the banks{no, Ellen is making the much narrower and entirely correct case that public infrastructure costs could be reduced by half if government self financed rather than borrowed from and paid interest to private bankers}. This is also entirely wrong. If a government company builds a car, the capital it obtains in order to begin production has, all else equal, the same cost as if Toyota were to obtain that capital. Capital costs do not disappear because production is socialized in the realm of government ownership. Capital still remains scarce {Ellen is not writing about the costs of real capital; she is writing about the costs of finance capital—borrowed money; we see in this paragraph how Rozeff is using the term “capital” to mean at one and the same time the real resources that go into the formation of fixed capital, and the money that activates that economic process; the “real” cost of fixed capital formation is labor and the opportunity cost of using economic goods like tools and machinery and diesel fuel to physically build the capital; the “financial” cost of fixed capital formation is interest paid on borrowed money; real capital and financial capital are two entirely different kinds of things that have two entirely different kinds of costs; Ellen is writing about the interest cost of finance capital, but Rozeff cannot distinguish that there are two different kinds of things in play here}.
    Furthermore, Brown exaggerates the amount of capital supplied by banks {banks supply zero real capital and banks ultimately supply 100% of financial capital, as all of our money supply originates as bank loans; even central banks “lend” currency to commercial banks, so even cash is lent into circulation in the economy; all money is lent into circulation by our banking systems, so banks ultimately provide 100% of financial capital because banks provide 100% of our money supply}. Somewhere around 60 percent of debt capital is supplied to businesses by the direct purchase of debt instruments in capital markets (estimated using the flow of funds accounts){where did the money come from in the first place, that businesses now hold as their profits that they reinvest? The money came from banks as loans, and as long as those loans are outstanding the money that was created by those loans is out in the economy, where it is accruing interest to the banker who lent it; the business who earned the money as profit does not owe the money and interest to banks, but the borrower who used the money to buy the business’s product still owes the money and interest; the rest of Rozeff’s argument about the source of finance capital is thus moot, as he’s talking about money that has already been loaned and spent into the economy by the ‘primary’ money supplier—banks–and is thus now in the ‘secondary’ money markets}. Banks don’t supply much long-term debt to businesses. Since debt is about 1/3 of overall capital and the rest is equity, banks supply about 0.4 x 0.33 = 13.2 percent of all capital to businesses. These are rough figures, but refinements won’t change the overall conclusion. Even if Brown’s nirvana of socializing or nationalizing banks were brought into being, it wouldn’t touch the vast majority of capital that is directly supplied to companies.
    I will now argue that her 40 percent figure is vastly overstated. To do that, we will take an excursion through the basic finance of which Brown is apparently ignorant.
    What is capital? Capital consists of all goods that people intend to use for activities that are intended to satisfy future wants, as opposed to consumer’s goods that are used to satisfy immediate wants. Capital is measured in terms of a money unit of account {here is Rozeff using money as an imaginary unit of account, rather than as a real factor; he believes the real economic goods are merely ‘represented’ by the money unit of account; and he thinks the only real kind of capital is “real” capital; in fact money is real and is different from real capital}.
    Businesses that produce goods for future consumption use capital in their processes of production. This capital is scarce, which means it is definitely not free or costless. There is competition to obtain capital. There are markets for it called capital markets {no, competition for real economic goods does not occur in “capital markets”; capital markets are the secondary markets in which “money” is borrowed and lent; commodities markets, and the real economy in general, are where real economic goods are offered for sale and are purchased}. There is supply of capital {i.e. people offering to lend money they already have} and there is demand {people who want to borrow money from someone other than a bank}, and their activity produces a cost of capital that is positive or above zero {see Steve Waldman’s explanation of “The negative unnatural rate of interest” http://www.interfluidity.com/v2/2535.html , which refutes the idea that there is always a positive price to lendable money: in the situation called a “savings glut”, which corresponds dollar for dollar with a “debt crisis” because the savings and the debt are just the two sides of the money balance sheet, the lendable value of money actually sinks below zero}. If the price or cost of capital were zero, the demand for it would vastly exceed the supply {we have negative real interest rates right now—Japan has had it for 20 years–and borrowers are not stampeding to their banks to take advantage; in a balance sheet recession households and firms are trying to pay down debt to get solvent, not borrow more money to get more stuff, so there is negative demand for lendable money no matter how cheap; indeed, Waldman argues that savers should be paying borrowers to carry their money for them into the future, and that the real value of lendable funds can approach negative 100%!}.
    All capital has a cost, which is in fact called the “cost of capital”. This cost doesn’t vanish if a business owner supplies his own capital to his own business. A person who uses his own capital in his business loses the opportunity of supplying it to others at the market price {if the market price is zero or negative, then there is a zero or negative ‘cost of capital’, contrary to Rozeff’s assumption that capital always has a positive cost}. He loses income that he could have gotten by allowing others to use his capital {or he spares himself the expense of paying somebody to carry his money into the future for him}. This person has an opportunity cost of capital. If he makes a rational calculation and accounting, he should demand of his business that it pay back to him this implicit cost of capital that he has diverted away from an external market and used instead for his own business purposes. What he has given up by not placing his capital in an external market he should at least recover by using it for his own purposes. He should, in essence, pay himself for the use of his own capital {or conversely, he should charge himself for carrying his own money into the future; curiouser and curiouser}.
    The cost of capital doesn’t vanish if a government takes capital from its citizens and uses it for government activities or government-owned businesses {Brown is not advocating government take anything from citizens; she advocates government create its own BRAND NEW financial capital just like private banks do}. If we think of the government as a kind of organization owned by citizens, then, in the employment of capital by the government, the citizens are analogous to a business owner that employs his own capital in his business {this is a good point}. That is, there is still a cost of capital used by the government when citizens supply their capital or are forced to supply it to the government {unless real labor and resources are unemployed, in which case there is a net benefit, not a cost, to employing them}. They lose the opportunity of deploying this capital elsewhere in productive enterprises {Is Rozeff seeing productive enterprises that are going undone because government is consuming all of the available labor and economic capacity? Which century is he looking into? Certainly not our time, which is nothing like what Rozeff is describing.}, and that loss measures the cost to them of government’s absorption of the capital.
    In other words, no magical gain occurs when government absorbs and deploys the capital that it extracts from citizens {true, but this doesn’t describe reality}. The basic reason that no gain occurs is that capital is scarce, which means it has a cost {again, if the cost is negative, then there is a positive benefit if government employs that slack capital}. That cost doesn’t vanish as capital is shifted from one owner to another, including government ownership.
    Brown fails to recognize this basic fact {Rozeff treats the principles of his economic model as if they are the real world facts we are currently dealing with; but his model describes an imaginary barter economy where economic resources are scarce, when in reality we live in a money economy where economic resources are abundant but effective demand is scarce}. She wrongly thinks that if government keeps the interest that it gets its projects at half price {She is precisely correct on this point, and Rozeff is exactly wrong}. All that happens, however, is that government recovers the cost of capital for itself. The projects don’t cost any less at all. Her error is like thinking that a man who uses his own $3,000 to build a motorcycle can build it at half the cost of someone who borrows the $3,000 from a bank to build it {If the borrower mortgages the loan over 25 years he will end up repaying $3000 principal plus pay $3000 interest = $6000}. Obviously the costs of the materials, labor, and so on are the same. The cost of the capital is less obviously present. With bank borrowing, the man pays interest. Let us suppose that it’s at 6 percent for one year, so he pays $180. The man who uses his own $3,000 loses the opportunity to invest his funds externally {Today he can invest his funds in a safe bank deposit or CD and receive a negative real rate of interest; i.e. it costs him money to keep his money in the bank, to ‘invest’ his money where there is a good chance of at least getting his principal back in full}. If he can invest at 6 percent, he loses $180. This is a real cost to him of using his own funds. There is a finance cost regardless of whether the bank funds the project or the man funds the project himself.
    All users or demanders of capital bear the cost of capital. They pay it to capital suppliers to induce them to save, that is, to forego consuming their resources and instead to invest them {I bake 20 loaves of bread and consume 2. How do I ‘invest’ my excess production? The bread is worthless after 3 days. I can give it to the hungry, or I can ‘lend’ it to them. But if I am a producer of excess value and they are consumers of value, how are they EVER going to pay me back? They aren’t, therefore “debt crisis”}. The cost of capital also includes payment for the risks that savers bear when they transfer their capital to the users of capital.
    Next, I expose the absurdity of her 40 percent number.
    How large are capital costs? A significant company might have 1/3 debt and 2/3 equity capital. The cost of debt might be 6 percent. The cost of equity might be 9 percent. The weighted average cost, excluding tax effects, is then 8 percent (1/3 x 6 + 2/3 x 9). These numbers are made up, but they give a reasonable idea of overall capital cost. I will use that 8 percent figure below.
    A company employs capital and it has a balance sheet. On one side, the left hand side, are the assets employed in the business. The left side provides measures in money terms of the assets that the business managers have decided to employ in the business in their production processes, such as buildings, a cash account, inventories, vehicles, computers, etc. The left side assets are capital in forms thought to be productive. On the other side of the balance sheet, the right hand side, are the liabilities (debts) and equity (or ownership) capital that finance the business. It shows capital in the form that capital-suppliers have agreed to make available to the business. The balance sheet always balances. The money valuation of the left side assets equals the money valuation of the right side liabilities and equity capital. We may use either total to measure the total capital deployed in the business {Aside from cash on hand and deposit balances in bank accounts, the left hand asset side of a (non-bank) business’s balance sheet describes the money value of the “real” assets of the business, while the right liability side describes the money debts owed by the business-including equity owed to the owners; this is a “business”, not a “person”, so the balance sheet shows what the business owns and which persons the business owes that stuff to; the business is just a vehicle for carrying assets and liabilities; all those assets are owned by/owed to “somebody”—as described on the right ‘liability’ side of the balance sheet; the balance sheet balances, so if the business is dissolved then all of its assets will be paid out to whoever owns its liabilities, and there will be nothing left but the empty shell of a business}.
    We see that the total capital employed in the business is measured in book value (accounting) terms by either all the assets on the one side or all the capital (debts + equity) on the other.
    Let’s do a hypothetical example in which we use the cost of capital as 8 percent. Suppose the company has $100 of assets. Then it has $100 of capital in the business. These assets have to earn $8 in order to cover capital costs of one year. Suppose that the business has sales revenues of $150 during the year. The revenue is not business profit. Much of this revenue will be absorbed by operating costs, such as payments for labor services, payments for energy, payments for goods purchased from other companies, payments for transportation, payments for advertising, payments for distributions, etc. One of the costs is the cost of capital. On income statements that calculate business profits, the costs of debt are explicitly accounted for by interest costs. The costs of equity capital are not explicitly accounted for, but they are still real. It is a mistake to overlook them.
    Business managers attempt to lower their costs so as to produce greater profits. They will attempt to obtain capital to finance the business at the lowest cost they can, all else equal. They might conceivably measure their capital cost as a fraction of their sales revenues. This ratio is not one that is ordinarily calculated in doing a financial analysis. This is the ratio that Ellen Brown cites and relies upon as being about 40 to 50 percent {No, Ellen does nothing of the sort; she is talking about the total interest that a typical borrower pays on a mortgaged asset such as a public capital project or a private house, and the interest paid over the amortization period is about equal to the original principal amount; therefore interest comprises 50% of the total money paid for the asset by the borrower; Rozeff’s argument does not engage what Ellen is talking about so his argument is moot}.
    In our example, the ratio is $8/$150 = 5.33 percent. The estimate of 40-50 percent intuitively seems way too high, and it is way too high. It means that on a complete income statement of this company the capital costs are $60 to $75. Suppose we use the 40 percent number or $60 of capital costs. Suppose that debt costs are 6 percent. With debt as 1/3 of capital, that means that debt costs are 0.06 x $33.33 = $2. That leaves $58 for the equity costs. The equity costs are $58/$66.67 = 87 percent. This is outlandishly high. It is caused by Brown’s outlandishly high estimate of 40 percent capital costs. Actual equity costs in the real world are nowhere near 87 percent. They range from 8 to 15 percent for many established corporations. They run higher than that for more risky enterprises, perhaps 15 to 25 percent. They don’t run 87 percent for businesses with reasonable prospects.
    What would be more reasonable? In my example, if $8 are capital costs and if $2 of this is for debt, then the remaining $6 is for equity. The equity cost is then $6/$66.67 = 9 percent. That is more reasonable. Very long run returns on common stock equity are near this number. Long run returns on the accounting value of equity may run somewhat higher, more like 10-12 percent. That still comes nowhere close to a number that justifies the assertion that capital costs are 40-50 percent of the selling price of goods, and that is what Ellen Brown asserts:
    “According to Margrit Kennedy, a German researcher who has studied this issue extensively, interest now composes 40% of the cost of everything we buy. We don’t see it on the sales slips, but interest is exacted at every stage of production. Suppliers need to take out loans to pay for labor and materials, before they have a product to sell.”
    Brown’s bottom line proposal is that the government create money instead of the banking system. She wants the government to set up its own banks. She says that this would bypass “the interest tab” {It most certainly would do this}. We have seen that this doesn’t bypass the cost of capital at all {not the cost of real capital if that cost happens to be positive rather than negative; but it does bypass entirely the money cost of financial capital}, not when that capital comprises real resources and the government absorbs these resources. But Brown has another fallacy in mind which is that fiat currency will eliminate the capital cost. She wants the government banks to issue fiat currency which is non-interest bearing and in this way fund projects at what she thinks is a zero capital cost {She is right; it is zero financial capital cost, as governments create the money out of nothing and pay no interest on it, so government can finance financially “free” infrastructure by creating its own financing; and if the real capital had been lying idle, then there are positive benefits to employing it rather than costs}.
    Picture a government printing press for currency. Citizens are required to accept the newly-printed paper in payments for goods. Obama’s lieutenants take the paper currency and spend it for their favorite projects. All this amounts to is a different kind of taxation scheme by which the government absorbs (seizes) resources that are in limited supply {No, Obama employs resources that were lying idle}. The opportunity costs of these seized resources still do not vanish no matter whether the resources are seized directly, taxed through the IRS, or obtained by spending new pieces of green paper {The opportunity cost was negative, which means the ‘seizing’ and spending produced a net benefit, not a cost}.
    Brown is committing the same fallacy as the Communists who attempted in vain to get rid of interest. It is an impossibility. The interest measures the postponement of consumption and arises because of it {How much will you pay me to let my bread rot rather than eating it today? Don’t I “deserve” payment for virtuously postponing my consumption? And if I do manage to give the bread to somebody else it is by selling (I get fully paid for my virtue) or lending (to somebody who ultimately cannot repay me); so much for the economic virtues of “postponing consumption”}. If there are to be any production processes, they require capital and non-consumption {Utterly false! Businesses produce and distribute incomes to workers and suppliers, who then purchase and consume the output, and the business reinvests in new production, and the process goes on. If people save their income rather than spend it, the business will not be able to sell all his wares at cost price, and he will reduce production and employment, which reduces incomes, in a recessionary spiral. The idea that investment can ONLY happen if there is saving first, is just imaginary and does not describe how things have EVER worked in the real world}. There will have to be interest. If interest is forcibly suppressed, capital will flee {Capital will flee to where, exactly? In a global balance sheet recession, the kind you get in a globalized economy, there is no safe haven of high interest for capital to flee to} and people will engage in greater consumption. Capital will be consumed and the economy will go downhill {Is Rozeff suggesting that the citizens of Michigan are going to eat Detroit because interest rates are too low? How do you “consume” fixed capital?}. Government printing presses amount to taxes on capital {True, if government prints and spends lots of money, this dilutes the value of people’s money savings; But conversely it also increases the money value of people’s real assets; If Rozeff wants to encourage investment of money into real assets, government money printing should suit him just fine}. They will have the same results.
    There is much that is wrong with our monetary system {Like what, for instance? Rozeff seems quite content with the status quo}. There are a good many critics of it who are offering sound criticisms and sound recommendations for improving it {Yes, return to gold, balanced budgets, austerity for all and sundry. Causing unemployment and human misery is “sound” monetary and fiscal policy}. Ellen Brown is not among them.

  2. Comment by email from Ernie:

    That it is a good idea for the government to save 50% on projects by not paying interest to private banks is common sense. It would be a huge improvement in the efficiency of government. That it is a good idea for businesses and consumers to save the cumulative 40% in interest charges that presently go to parasitic finance capital is common sense too. Far from a communist scheme, as Rozeff fatuously asserts, it can set free enterprise free to do what it can do so well – produce abundance! So Ellen Brown is right: banking as a public utility, like roads, is needed for true economic freedom. Instead of bailing out casino banking again, let’s free ourselves from it!. It does not serve society, only itself. Interest charged can go to government so that we don’t have to pay taxes! That’s how it worked in Benjamin Franklin’s colonial Pennsylvania. See Brown’s Web of Debt for details.

    So, as she says, an economic bill of rights is affordable and sorely needed. How can people be free to pursue happiness without the economic basics that FDR described? Jobs, housing, and health need to be enshrined as priorities. How can we have we have democracy when the whole society is dominated by and skewed in favor of the hyper-wealthy? As Margrit Kennedy said, the uppermost 10% get — without working — all the interest payments that the bottom 80% pay. Brown shows us how we can make society more fair, decent, and free.

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