Recently by Michael S. Rozeff: Government by Force: Financially and Conceptually Bankrupt

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.