Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
"Capital" can be both a thing (a machine, an idea) or a relationship (an organisation).

"Financial assets," on the other hand, are promises. And financial assets are not capital.

One interesting little exercise to wrap your head around is to put ordinary double-entry bookkeeping in a slightly different form: The balance sheet for economic agent i can be written as

Ci + Fji + Bi - Ei - Fij - Rji = 0

summed over j, where Ci is the value upon liquidation of the capital of agent i, Fji is the long financial position of agent i in agent j (cash is a long position in the sovereign, while, e.g., student loans are a short position in the sovereign), Ei is the equity of agent i, Rji is the value of the risk of default by j on its obligation to i and Bi is the bezzle of agent i. The bezzle is composed of all the things that make a going concern more valuable than a liquidated concern - organisation, public confidence (whether misplaced or justified) in future earnings, brand value, political connections, as yet undiscovered embezzlement, etc.

Now sum the balance sheet equation over the whole of the private sector: All the financial obligations net out, and you're left with the identity

C + B + F0 - R = E

Where F0 is the net long position of the private sector in the sovereign (plus, in an open economy, the net long position in foreign countries).

The total equity in the private sector of your economy is, in other words, equal to the capital plant plus the net sovereign debt minus the net foreign debt minus the total cost of default risk, plus the bezzle.

What happens during a speculative episode is that the bezzle grows due to unjustified expectations of future revenue. This causes the total equity to go up, which allows (a) more of it to find its way into the hands of the wealthy and (b) total lending volume to go up, which makes aggregate lending risk go up too. Collective insolvency happens when the bubble bursts, leaving the bezzle unable to cover the increased aggregate lending risk.

(This analysis can, of course, be replicated for any relatively isolated sub-sector of the economy by replacing "sovereign" with "rest of the economy" in the above derivation.)

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Jul 18th, 2010 at 09:26:25 AM EST
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