On the Role and Effect of Investment on Economies
by jovialbard
Economies exist to solve one simple problem. Sometimes an individual has a surplus of one thing and a need for another. That’s the essence of it.
The simplest solution to this problem is through direct trade. However, direct trade isn’t the best way to resolve complex issues of supply and demand. The introduction of currency allows for more complex exchange interactions.
There is a different type of surplus and need that mere exchange, whether through barter or currency, cannot help to resolve. That is when the surplus is potential. The only way to trade someone a surplus of potential is to wait until that potential is actualized. This is where investment is introduced into an economy. An investor trades a surplus of resources now for some portion of the resources that exist when the potential is actualized. This facilitates a more vibrant economy by making it easier for new ideas to flourish.
When a particular sector of the economy flourishes it tends to profit above the normal living expenses of those in that economy. Essentially there is money coming out of the rest of the economy and accumulating in the profitable part of the economy. Part of those profits undoubtedly go toward improving quality of life. Such quality of life improvements are expenses that are thus recirculated through the rest of the economy. Another portion go toward investments. Investments that increase productivity are, again, expenses that circulate through the rest of the economy. Other investments may be made toward other sectors of the economy. So the majority of the money supply that pools in a profitable sector of the economy will, one way or another, eventually recirculate to the rest of the economy.
As an aside, I won’t attempt to moralize about whether these profits and localized gains in quality of life are ‘good’ or ‘evil’. That’s not what this essay is about. This essay is about mechanics, so I’ll save any discussion of morality for another day.
However, the picture is very different when looking at the investment sector of the economy. It doesn’t quite behave the same way, or rather, it does but with different results. When investors are successful it means they are profiting from their investments. These profits mean that some portion of the available money supply is flowing into the investment sector and accumulating there. Certainly a portion of these investments improve the quality of life of those employed by the investment sector. So there’s nothing different about that, but what happens to the rest of the profits? And surely there will be additional profits, what portion of investors is satisfied just earning enough to live on? Can it be invested in productivity? Not really. The investment sector doesn’t produce anything. Rather, the means of production for an investor is money. They can hire employees, but that’s essentially just an investment in another investor, it doesn’t employ anyone or require purchasing anything outside the sector of investment. So what do they do with the profits? Just like a profitable trader in goods and services they can invest the surplus. That is, the surplus goes into the investment sector… where it already was…
So essentially… as long as the investment sector is profitable on balance money will be flowing into the investment sector of the economy, but how does it flow out? How does it recirculate? You could say the loans that the investment sector provides to other sectors of the economy allows it to recirculate, but that isn’t really true. That money still belongs to the investment sector, it’s just temporarily being utilized by other sectors of the economy, they have to give it back at some point. The portion of the money supply owned by the investment sector hasn’t decreased at all. In fact, it has likely increased in the form of interest or shared profit.
Should this trend continue, with the money supply naturally flowing into the investment sector without ever flowing out, what happens to the sectors of the economy that produce goods and provide services? How can their share of the money supply do anything but shrink? How can they do anything but become increasingly dependent on loans from the investment sector? And as they become more and more dependent on loans, as their balance books look worse and worse, wouldn’t the investment sector itself start looking like the most tempting place to invest? Over time the idea of investing in investment would become more and more appealing. That’s where the winners are. As this happens less and less available money exists in the various sectors of real goods and services. The localized inflation of the money supply in the investment sector and deflation of the money supply in the rest of the economy would only accumulate. How could the cycle possibly end?
There is one way for the accumulation to end, for the money to flow back out of the investment sector: Failed investments. When an investor gives money to some venture without getting any back, that money has left the investment sector. The person engaging in the venture has spent it, more than likely on other goods and services. That money is now flowing through the economy of goods and services. The investor has no way to reach that money except to demand it from the venture they invested in. If that venture has failed to profit then it cannot get the money back. The investor walks away with less than he started but the economy of real goods and services now has money that it didn’t have before. Does that sound like a good thing? It shouldn’t. Why? Because that’s an investor whose ability to serve their vital role in the economy has been diminished. They are less able to actualize potential. When this happens dramatically we call it a bust. The investment sector, during a bust, is essentially suffering massive deflation. The whole economy suffers an inability to actualize potential and productivity temporarily grinds to a halt. In time the investment sector stabilizes. As it does it begins to serve it’s incredibly vital purpose in actualizing potential. As it does so more and more successfully it begins to slowly consume the available money supply. Boom, bust, boom, bust. There is no guarantee when the bust will happen, because, strictly speaking, it doesn’t have to happen. If the investment sector of the economy contented itself with owning the entire money supply it could continue to bankroll the rest of the economy with loans that can never really be paid off. Eventually, however, someone’s going to ask for their money back, and that’s when all the dominoes fall.
So is the cycle of boom and bust an inevitability, aside from the collapse of market principles altogether? I don’t see how it could be anything but inevitable without another way for money to flow out of the investment sector. Unless someone can enlighten me as to an alternative, it seems like an inescapable aspect of our current implementation of capitalism. Except… there is another way for money to leave the investment sector. Taxes. Taxes are often despised by capitalists because they have a deflationary effect on a market. Having money flow out of a market is generally not a good thing. However, that is precisely the nature of the problem with the investment market that my analysis here reveals. Unless my analysis is wrong then the only thing that can stop the inevitable inflation of the investment market ultimately resulting in massive busts is a complimentary deflationary effect. Taxes. Taxes are the salvation of capitalism.
I’m not suggesting the government ‘redistribute wealth’ out of some sense of egalitarianism. Nor have I mentioned anything about ‘means of production’. This isn’t a Marxist or Humanitarian argument. This is an economic argument. This whole analysis started with a discussion of how important investment is to the effective functioning of an economy. I have made no attempt to demonize capitalists. I have not suggested that this boom and bust cycle is the result of greed or ill intentions. Even if I were to take a Marxist perspective I would argue that investment is it’s own form of labor and should be respected as such. It is simply the case that an investor’s tools are money, his skills are business sense, and his product is actualized potential. A valuable commodity to be sure. However, it seems to be an inescapable truth of our contemporary system of capitalism that it’s very nature is to implode. That statement does not undermine the power of capitalism to match supply with demand. That statement does not suggest that there is another existing system that is better. It is possible that there is a better alternative than our contemporary understanding and implementation of capitalism, that we are missing something, or making a wrong assumption somewhere, but that is a discussion for another day. What remains from this analysis is that the only means of contemporary capitalism to not destroy itself is taxes. The only way to ensure stability is taxes. Taxes, given our contemporary understanding and utilization of capitalism are an essential good necessary for the smooth functioning of our society and our economy. Without taxes the markets for real goods and services will invariable suffocate in debt and the market for investment will invariable inflate and inflate until it implodes. This is not a condemnation of capitalism, it is a statement of fact. Unless I’m missing something vital, taxes are the salvation of capitalism for its own sake, not a necessary evil for ours.
jovialbard 
The conclusions this article comes to are astounding to me. Which may be a clear indication that I am utterly misguided. If that is the case, and you can explain how, please, I want to understand. I wrote this as a thought experiment for the purposes of understanding. If there is something more that I could come to understand by your input, I am very much interested in that. So be civil and thank you for commenting.
(Assuming this article is actually read by anyone)
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Great article. I was thinking about this for a while before commenting. Here are some thoughts:
I’m assuming that the investment sector generally means banks. With that in mind I started with a mental example of the investment transaction to think about the flow of money. A bank lends 100 dollars to a business. That business is successful and repays the loan with interest for a total of 120 dollars. The bank profits and most likely the business has profited as well, otherwise it could not have repaid the loan. So say the business earned 40 dollars over the 100 it started with. 120 goes back to the bank and 20 is profit for the business. So where did the 40 come from? Customers. So the money flowed from customers to both the business and the investment sector.
When the bank makes a profit, they can either retain that money or pay it to the owners as a dividend. If they retain it and choose to grow, that is money flowing to the investment sector. As you say, they can continue to use this increased wealth to invest in further innovation. However, as large as the world is, I think good/profits innovations available at any given time are finite. Once all the ‘good’ ones have been invested in, the ability for the investment sector to continue drawing wealth from the rest of the economy SHOULD stop. Obviously some get greedy, make poor investments and either lose money, or persuade someone else that these are good investments and resell them at a profit. The latter being what leads to the bust. If you generally assume the latter does not happen for the sake of argument, there should be an equilibrium for the investment sector once investments/innovations are exhausted.
Another simpler way to imagine the steady equilibrium of the investment sectors wealth is risk and reward. If I expect a greater risk, I require a greater profit. So any given investment should yield approximately the same long term benefit and that should not outweigh the profits achieved by any other sector or people would choose to enter those other sectors. (Low risk I expect 5% but have a 5% chance of losing the investment / high risk I expect 50% but have a 50% chance of losing the investment)
The other piece of the investment sector is the owners who get those dividends. (Are they themselves the ‘investment sector?’). If so, what do they do with their wealth? They can out it in stocks – owning the goods and services companies, put it in bonds – lending money or investing – most appropriate here, or it is redistributed by either taxes or charitable donations. Two other options are it being stuffed In a mattress which creates no flow of wealth or putting it in a basic bank account where the bank will invest it bringing us back to the top. Finally they can also spend it as consumers.
Getting back to the point, is ot inevitable that wealth will continue flowing to investors until they have so much wealth that the economy busts and the cycle starts again? I’d say it’s not inevitable and further should not happen ever. At least not by nature of their choice to invest.
So why the booms and busts? I really don’t know. Some guesses are fraud in the market and imperfect information, periods of greater than usual innovation and stagnation, and human qualities like recensy (sp?) bias, where people get very excited and over confident throwing money into good markets driving the up beyond reasonable levels or get over conservative pulling money out of bad markets driving them below reasonable levels.
What do you think?
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Investment sector means any exchange where resources are traded for potential resources. Banks, stocks, and speculative real estate are all investments. For example. A traditional home buyer goes into closing with money and walks out with the things they wanted, a home to live in. A flipper goes into closing with money and walks out with something they don’t want. They don’t want that house, they want the profit they will make when they sell that house in the future. That’s essentially the difference.
The central point of your argument seems to be that at a certain point investors will stop investing and be satisfied to just spend their money. That may be the case with small investors. Going back to the home flipper, after a few years they may retire, spend a majority of their savings on living expenses, then die and leave the remainder to their children to spend on education, luxuries, or starting their own businesses. However, this does not appear to be how the investment sector works broadly. A successful investment company is not one that makes enough to pay it’s employees, it’s one that makes enough to grow it’s pool of capital. In general, the investment sector of the economy appears to be good at this. You’re right though, if an economic analysis should show that, on average, investments tend to only pay for quality of life improvements, then my argument falls apart. However, if investments, on average, tend to grow, then we must be experiencing a shift of money supply from the realm of exchanging goods and services into the realm of investment. The share of the money supply belonging to investment has grown.
I think the thing to keep in mind that investment is also subject to the laws of supply and demand. An investment earns its value based on its demand. Its demand is a function of how appealing it is to other investments. The money in the investment market has to go somewhere, so it will go into the investment that is most appealing. Why would this reinvestment stop before the most appealing investment is proven to be a bad investment? Where else can the money go? And when the most appealing investment is a bad investment, what does that say about the well-being of the economy? It says that a good bust is in order. Now sometimes the appeal is based on an illusion. There was a small benefit in perceived value that encouraged investment. When that perceived value turns out not to exist the bust is small and localized. However, assuming an investment market that is successful, where everyone is investing as well as they can, as long as that market continues to see profits it will be consuming the available money supply and eventually the most appealing but bad investment is something huge, like the housing market.
You’re right, investments in one sector will generally, assuming perfect investor performance, provide the same profits as investments in any other sector. Risk and reward will balance. But I’m not talking about comparing investments in different sectors. I’m talking about the sum of all investments. If the sum of all investments are, on average, profitable, then money supply is flowing out of the economy of goods and services and into the investment sector. The economy of goods and services is the man walking down the street with $10 in his pocket looking for a burger. He isn’t investing in a burger. He isn’t looking to actualize the potential of the burger. He wants the damn burger. He is in the “here and now” economy. Again, that’s not to say his economy is better or more moral in some way, but the fact remains that if the investment sector, as a whole, profits from the economy of goods and services, then over time the money in everyone’s pockets to go buy burgers is less. That money is now bundled up in investments. They may still have money in their pockets if they take out a loan or live off of credit, but that money ultimately belongs to the investment sector, they have to pay it back, it doesn’t really belong to the economy of real goods and services. It’s just visiting.
Yes, someone who collects dividends is collecting on an investment. Putting it in stocks, bonds, or lending would all keep it in the investment sector of the economy. So the only thing you mention is quality of life or charity. I had a paragraph about charity in my essay but decided it wasn’t essential and wanted to keep things simple. You’re right, that’s another way that money can flow out of the investment sector. Is that really the capitalist ideal though? One sector of investors controlling the entire money supply with the rest of society living off their charity? I’d rather not rely on charity as the primary means of reversing the natural inflation of the investment sector, the implications of that are… grim. So yes, there’s quality of life, that’s the only thing left. So the question remains. In sum, does the investment sector only pay for the quality of life of it’s employees or, in sum, is the investment sector growing and making a profit beyond quality of life improvements? If it is growing beyond the scope of quality of life improvements, then it is accumulating ownership of the money supply.
That’s the central question upon which this argument rests. Does investment just pay the bills of the people investing, or does it earn a profit beyond that?
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