1.1.12 Capital rotation rate

As we already said, most of the concepts we find nowadays in modern textbooks are already described in Wealth of Nations and what is not in Wealth of Nations, we can find in Principles of Economics of Alfred Marshall.

The difference is that Adam Smith presents these concepts very often "passing by", in a note in a subordinate clause without paying attention to it. If one took a closer look at this book, perhaps more elements of the present academic economics could be found, see an economic perspective.

It is obvious that our presentation of the book is somehow "heuristic", but at least, we show that Wealth of Nations is more that what have been canonised in the academic curricula.

Adam Smith, for instance, already realised the importance of the retail industry, although he mentions only one function.

(Actually, the problem is more complicated. Retailers must offer a certain range of products, and there are a lot of different strategies and every few years, we see appearing new types of retailers with different strategies.)

The central function of retailers for Adam Smith is to split up big portions in little ones.

Unless a capital was employed in breaking and dividing certain portions, either of the rude or manufacturer produce into such small parcels are suitable for the occasional demands of those who want them. Every man would be obliged to purchase a greater quantity of the goods he wanted than his immediate occasions required. If there was no such trade as a butcher, for example, every man would be obliged to purchase a whole ox or a whole sheep at a time.

aus: Book II, Chapter V

Capital rotation defines the time capital is spent and returned for a certain period. If a company, for instance, buys products for 1000 dollars and sells these products, and does it three times in one year, then the capital rotation is three. It looks simple, but it has massive consequences.

The capital rotation rate explains the different business strategies. (Not only in the retail industry, but everywhere.) If a supermarket sells products for 1000 dollars and the earning is 100 dollars, they earn 300 dollars if it does that three times a year..

The jeweller has an entirely different strategy. His capital rotation is only 1 per year, but his earning is higher. If he earns 300 dollars on one capital rotation, he gets to the same result as the supermarket.

If we compare drugstores with supermarkets, it's obvious what happens. Drugstores try to reduce their inferior capital rotation by reducing costs. They don't have products that must be cooled; they have less expenditure for employees filling up the shelves, fewer employees for representation of the products etc.

It is obvious that the importance of the rotation of capital questions as well the neoclassic model and especially the model of Léon Walras. The theory of Léon Walras is based on the study of markets where products are CHANGED, but not PRODUCED. In other words, it's a short period consideration. See markets in the short run and in the long run. This is already a problem because this kind of short-run analyses is almost irrelevant for market economies. But besides that in his and similar analysis only are taken into account the costs and the price. This is only a part of the whole picture.

Alfred Marshall makes a clear distinction between the short-run and the long-run, even in modern textbooks we find only a short-run analysis. We will return to the topic in equilibrium in the short run and in the long run.

Adam Smith mentions the rotation of capital as a mere annotation in a chapter that addresses the relationship between the labour market and the use of capital. His analysis of the rotation of capital is right, but the conclusions he draws from that are wrong. This is due to a fundamental misconception of the nature of capital. This misconception leads to many errors as we will see in the following chapters. Adam Smith assumes that employment depends on the amount of disposable capital.

The amount of work companies create depend on the profitability of this work i.e. from the qualification. If the rentability of a company is for instance 6 percent ( profitability = (earnings/capital) * 100) it can borrow money at 4 percent, but there is no need that someone has saved this capital before. Even if the bank doesn't have the money, they can create this money with scriptural money and if they can't the central bank can print it. There is only one relevant question. Will the company be able to pay back the loan? If this is the case, the money created before will be eliminated after. That’s what actually happens every day. Capital, understood as not consumed parts of previous income, is not needed.

The basic error is in the fact that classic theory doesn't distinguish between capital and money. Capital is not consumed, in other words, saved income from the past. Money is just a means of payment.

Some readers may argue that in times of Adam Smith, the only way to get the money needed for investment was to save it before, because the bank system was not able to produce money. That's wrong. Adam Smith himself describes methods how banks created money, see balance of payement.

If we disregard the wrong conclusions he draws, his statements concerning this topic are correct, although it is not very clear why it takes more time to get back the capital invested in foreign trade.

The returns of the home trade generally comes in before the end of the year, and sometimes three or four times in the year. The returns of the foreign trade of consumption seldom come in before the end of the year, and sometimes not till after two or three years. A capital, therefore, employed in the home trade, will sometimes make twelve operations, or be sent out and returned twelve times, before a capital employed in the foreign trade of consumption has made one.

aus: Book II, Chapter V

His definition of fixed capital is not really helpful. He defines fixed capital as capital that only returns in the long-run. Thats not really the point. The question is, this topic is essential for understanding the Keynesian theory, see the little book downloadable from the homepage of this website, the proximity to the most liquid form of capital, money. If something can be sold at any moment, for instance a house, it is near to absolute liquidity. In other words money, the most liquid assets are obviously the securities, which are traded on the stock markets.

Time, as affirmed by Adam Smith, is not the crucial point. The crucial point is liquidity.

The returns of the fixed capital are, in almost all cases, much slower than those of the circulating capital: and such expenses, even when laid out with the greatest prudence and judgment, very seldom return to the undertaker till after a period of many years, a period by far too distant to suit the convenience of a bank.

Book II, Chapter V

In business management, his definition is not very useful neither. In business management, fix costs are the costs which should not be taken into account in the decision to produce a product or not.

If a company produces for instance icecream, the costs of the refridgerators are irrelevant for the decision to produce a new type of icecream because they need them anyway. An example and more easy to understand: The infos24 GmbH, the company behind this website, already has computers for internet hosting. The decision to host the websites of customers or not doesn't have any impact on the cost. In other words, we host them at any price. It's just some extra money.

The problem is different. Capital invested in specialised machines very often can't be sold at all. In other words, if it turns out that the project is not profitable, the value of this kind of machine corresponds to its scrap value.

That's the reason for the Keynesian liquidity preference theory. Investors prefer to invest in liquid assets, assets reconvertible in the most liquid form of capital: money. The more insecure the future is, the greater the preference is for liquidity.

The last sentence, "...a period by far too distant to suit the convenience of a bank..." addresses a problem, but doesn't really explain it. Even if the idea of Adam Smith would be true that investments depend on capital, previous savings, the affirmation wouldn't be true. Banks, other institutional investors like insurance companies were inexistent at the time of Adam Smith, had the possibility to loan money for a long time. They subsitute one credit for another. (Customer A gives them 1000 dollars for one year, they borrow to company B 1000 dollars for 4 years. After one year, they had to give back to A his 1000 dollar. B has already paid 750 dollars. In order to pay back the money due to A, the bank needs a customer C, lending the bank 750 dollars for on year and so on.)

Time is not the problem; insecurity is the problem.

If we consider the problem under the conditions of the real world, time is still less important. In modern economies banks can get any amount of money they want. They produce it themselves. However, the problem remains the same; insecurity.

Banks and other institutional investors invest in a conservative way. In other words, they prefer investment in houses or financial assets. These investments are more liquid, but if everybody invests in the same assets, the risks of bubbles rises.

The basic problem is that banks want 100 percent security and good money for their money. The best of both worlds, but these worlds are not compatible with each other. 100 percent security is only possible, if the borrower can give securities, for instance his private fortune. However, there is no guarantee that the people who can give that, have as well the best projects.

It is pretty clear that highly industrialised countries can only continue to grow if they invest in projects, where no data are available, which are therefore risky. The famous "German Economic Miracle" after World War II was no miracle at all. They only did what they have done before and the investments were based on prior experience.

Banks and institutional investors like insurance companies will, therefore, become more and more irrelevant in the future and more and more projects will be financed by venture capital. Venture capital want to make a lot of profit, but they take risks.

They don't demand securities, they don't lend money. They participate in the company. This leads in general to a lose of money, but one success is enough to compensate for all the losses.

If institutional investors want to follow the same strategy, in the long run they will be obliged to do that because they need more qualified people. People able to evaluate complex projects. Right now, they employ different types of economists. These people can move around curves, but that it is not what is actually needed, see preliminaries.

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