Grounding Economics in Commercial Reality: A Cash-Flow Paradigm

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Grounding economics in commercial reality: A Cash-flow Paradigm Shann Turnbull [email protected] The Fifth Australian Society of Heterodox Economists Conference University of New South Wales, Central Lecture Block 11-12 December, 2006 Abstract Cash-flow rather than profit is presented as a basis for grounding the discipline of economics in commercial reality. It allows the traditional remit of economics to be expanded from the production and exchange of goods and services to also include the exchange and transformation of assets and liabilities. In the cash-flow paradigm wealth is not defined in terms of income, but according to the commercial definition which is the value of assets less liabilities. Traditional economic analysis cannot detect when investors get over-paid to create inefficiencies and inequalities and so identify either the need or means for reforming capitalism. Nor can orthodox economics based on the production and exchange of goods and services identify how individuals, corporations, governments and society increase or lose commercial wealth. The cash-flow paradigm introduces an inclusive methodology for understanding, evaluating and designing economic institutions and the process of economic development. It explains how development is achieved in commercial practice and shows why the World Bank, other international and domestic development agencies can change their operations from providing credits to providing the knowledge of how to make economic development self-financing – a condition for individuals, towns, regions and nations to achieve financial and so political independence.

Key words: Cash-flow paradigm, Confluent Development, Contrary Development, Degenerate assets, Market failure, Procreative Assets, Self-financing Development, Self-governance, Surplus profits, Surplus value. JEL classifications: B41, D23, D24, D31, E20, F34, G30, O12, P11

Shann Turnbull PhD, Principal: International Institute for Self-governance PO Box 266, Woollahra, Sydney, Australia, 1350 +612 9328 7466; Mobile: +6141 222 378; Skype & Google ID: shann.turnbull

Grounding economics in commercial reality: A Cash-flow Paradigm Perhaps it is fair to say that no paradigm is firmly ensconced today. We live in a period in which much of the conventional wisdom of the past has been tried and found wanting. Economics is in a state of self-scrutiny, dissatisfied with its established premises, not yet ready to formulate new ones. Indeed, perhaps the search for a new vision of economics, a vision that will highlight new elem`ents of reality and suggest new modes of analysis, is the most pressing economic task of our time.

Heilbronner and Thurlow (1984: 44) 1. Introduction Cash-flow rather than profit is presented as a basis for grounding the discipline of economics in commercial reality. It allows the traditional remit of economics to be expanded from analyzing the production and exchange of goods and services to also include the exchange and transformation of assets and liabilities. The cash-flow paradigm introduces the concept of surplus profits to reveal inefficiencies and inequities in market economies and a so a basis for their amelioration. In the cash-flow paradigm wealth is not defined in terms of income but according to the commercial definition which is the value of assets less liabilities. Traditional economic analysis cannot detect when investors get over-paid to create inefficiencies and inequalities and so identify either the need or means for reforming capitalism. Nor can orthodox economics based on the production and exchange of goods and services identify how individuals, corporations, governments and society increase or lose commercial wealth. The cash-flow paradigm introduces an inclusive methodology for understanding, evaluating and designing economic institutions and the process of economic development. It explains how development is achieved in commercial practice and shows why the World Bank, other international and domestic development agencies can change their operations from providing credits to providing the knowledge of how to make economic development self-financing – a condition for individuals, towns, regions and nations to achieve financial and so political independence. The concepts introduced by a commercial analysis of economic activity require new words to communicate them1. Words are the tools of thinking and a number of common words used in traditional economic discourse can be difficult to define and/or can have ambiguous meanings. Commonly used words like “wealth”, “capital”, “productive asset”, “economic rent” and “profit” are examples. To reduce these problems some commonly used words like “capital” and “economic rent” are avoided and others given a new meaning like the word “profit” which is taken to mean “incentive”. The word wealth is also given a different and unambiguous meaning from those in the index found in text books that refer readers to “see income” (Samuelson 1970) and not mentioned at all by Williamson (1985) in his treatise on The Economic Institutions of Capitalism. The non traditional concepts introduced by the cash-flow paradigm require their own distinctive words such as “procreative assets”, “degenerate assets”, “surplus value”, “surplus profit” “confluent development” and “contrary development”. These are defined in the Lexicon of the Cash-flow paradigm presented in Appendix I of Turnbull (1992) on which this paper is largely based. New concepts and words to describe them are required to allow economic activities to be analyzed in a more precise and meaningful way to achieve a more efficient, equitable and sustainable economy. For 1

This is consistent with the observation by Kuhn (1980: 149) that “Since new paradigms are born from old ones, they ordinarily incorporate much of the vocabulary and apparatus, both conceptual and manipulative, that the traditional paradigm had previously employed. But they seldom employ these borrowed elements in quite a traditional way”.

2

Grounding economics in commercial reality: A Cash-flow Paradigm a similar reason, the Eskimos had numerous words to describe the word “snow” as the sustainability of their way of life depended upon distinguishing and communicating the subtle variations in its character. The need for extending the remit of traditional economic analysis to include the exchange and transformation of assets and liabilities in considered in the following Section 2. This Section also identifies some of the major differences between the limited remit of the traditional economic analysis and the more holistic cash-flow approach. Different assumptions on the behavior and needs of individuals are also considered. Section 3 introduces elements of the cash-flow lexicon to provide the intellectual tools for understanding how commercial wealth is created. Section 4 considers the ambiguities created by the word “capital” and why this word should be replaced by others. Section 5 identifies the differences between confluent and contrary development processes with Section 6 introducing the concept of surplus profits and how this contributes to inequity and inefficiency. Section 7 considers surplus profits achieved from windfall gains with some policy implications considered in the closing Section 8. The introduction of a new paradigm is described by Kuhn (1970: 82) as "extraordinary science" to distinguish it from "normal science". He saw the role of “normal science” was to assess such comparisons and a basis for this to be undertaken is presented in the next Section. 2. Differences between profit and cash-flow paradigms This Section outlines the major differences between the profit and cash-flow approach to economic analysis. The need for increasing the remit of orthodox economic analysis to create a more holistic framework that recognizes commercial practices and imperatives are indicated in Figure 1, Holistic Economics. The relative sizes of the four different shaded elements in Figure 1 are only indicative to illustrate how the cash-flow paradigm provides a more holistic basis to analyze an industrialized private property economy. The profit paradigm is represented by the top two shaded elements that involve the production and exchange of goods and services and monetary transactions. In socialist and primitive economies without property rights to realty and corporations, the bottom two shaded areas in Figure 1 would be missing. Theses elements were negligible when economics was founded in the 18th century by Adam Smith (1981). Only a very small minority of the population owned realty and fewer owned shares in corporations that required an Act of Parliament to be created. In modern private market economies the cash-flows arising from stock exchange transactions alone can exceed the value of the GNP without including the cash-flows arising from futures exchanges, bank bill markets, money markets, bond markets, mortgage exchanges and real estate sales. When these other transactions and those associated with transforming property rights, as occurs when bank loans are created, the resulting cash-flows can be a number of times greater than the GNP. The development of derivatives has greatly accelerated the value of economic transactions to be orders of magnitude greater than GNP transactions. This is why the remit of economic inquiry needs to be increased to consider all actual and contingent cash-flows as provided for in Figure 1. A similar situation occurred in the natural sciences. When Isaac Newton identified the laws of motion in the 18th century they made an invaluable contribution like Adam Smith did with the profit paradigm of economics. But as the study of masses approaching the speed of light became more relevant a new 3

Grounding economics in commercial reality: A Cash-flow Paradigm

Transactions

Cash-flow paradigm – Allocation of asset values not necessarily to scale

Profit paradigm

Figure 1, Holistic Economics Production and Exchange of goods and services Money

GNP Money

Transformation & Exchange of assets and liabilities

Assets and liabilities not exchanged or transformed in a year

Turnover in a year of all Stock Exchanges, Mutual Funds, Money Funds, markets for Bills, Debentures and Bonds etc., and all transfers of housing, commercial buildings, plant & equipment, etc.

Land, buildings, mortgages, private company shares, unincorporated enterprises, other equities including plant, equipment, machinery, intellectual property, automobiles, airplanes, boats, etc.

Profit and loss statement (Income & Expenses) Funds flow statement (Application & Source of funds) Balance Sheet (Assets & Liabilities) 4

Grounding economics in commercial reality: A Cash-flow Paradigm paradigm was required to take into account relativistic phenomena that were not relevant in the 18th century. Likewise in economics, transactions not involving the production and exchange of goods and services can no longer be ignored. However, National Accounts concern themselves only with the income and expenses of a nation, not its assets and liabilities. Commercial practitioners find it inconceivable that a statement of assets and liabilities is not a basic and routinely used tool for economists to keep track of the value and distribution of the assets and liabilities in a Nation, State or Local Community. In recent years some advanced economies are now producing national balance sheets but it has not yet become a basic and routine tool for either evaluating or managing an economy. On the other hand all corporations are required by law to prepare a balance sheet which lists all their assets and liabilities. The excess of assets over liabilities is called shareholders' equity or net worth and this indicates the value of a business. The success or failure in managing a business is determined by how the net worth increases/decreases over time. When an enterprise has liabilities in excess of its assets it is defined by law to be insolvent. The directors of a limited liability company become personally liable for the debts of the enterprise if they continue trading when their company is insolvent. This forces company directors to take careful note of the information provided in the balance sheet of their corporations. For a corporation or individual to borrow money, the presentation of a statement of assets and liabilities is a fundamental condition for obtaining a loan. The net worth of a business changes from both its trading operations as reported in its profit/loss accounts and/or from the exchange and transformation of assets and liabilities. The transformation and exchange of assets and liabilities involves changing the nature of its property rights/obligations or bartering such rights (e.g. corporate takeovers financed by stock swaps). It could also involve attaching contingent rights to deal in property such a lien to secure a borrowing or put and call options, etc. Such activities are the tools of trade of investment bankers, corporate raiders and property developers. The lack of national accounts that incorporate a balance sheet explains why economists did not anticipate the Third World Debt problem. Bankers discovered the problem in the early 1980's when they tried to collect some of their Sovereign loans. Economists' do, however, try to estimate the volume of money in the economy as this is considered a fundamental way to control inflation and so monetary transactions are shown as part of the Profit Paradigm in Figure 1. Because the ownership of assets and liabilities is omitted from National Accounts there is no basis for analyzing the ownership or sovereignty of cash-flows, which are included in the accounts. In some countries, with a large proportion of foreign ownership, a significant amount of national income may accrue to foreigners. So while the Gross National Product (GNP) of a country may increase, the average income accruing to each resident could decrease because a significant portion of the GNP or GDP accrues to foreigners. In this situation, a country can report economic growth and an increase in the standard of living while resident income decreases. On a regional basis, this blind spot of economic analysis may explain why many resource rich communities in market economies are cash poor. External ownership of natural resources, property and housing finance institutions means that the cash retained in the community may be only a fraction 5

Grounding economics in commercial reality: A Cash-flow Paradigm of the value of the production/income generated by the community. Rents and mortgage payment could drain away up to a third of the income of residents to external parties. Commercial rents, profit shares, fees, dividends and royalties could be much more. For this reason, no initiative to revitalize a community, region or nation state should be undertaken without first ascertaining the pattern of ownership and control of its land, buildings, enterprises and financial system. Otherwise resources contributed to development could be inefficiently and ineffectively utilized with most of the benefits accruing to external beneficiaries. One reason why economists generally consider that the nature of ownership does not matter is because they accept that the nature of ownership and its distribution is a given and not a variable subject to economic policies. This view is not accepted in the cash-flow paradigm where the nature of property rights to land, corporations and currencies is considered a variable subject to policy initiatives as identified by Turnbull (1992). Some other major differences between the profit and cash-flow methodology are compared in Table 1, Differences between Profit and Cash-flow Paradigms. Row 1 recognizes the additional types of transactions in the economy as presented in Figure 1. Other differences are raised in later sections of the paper with the last row 12, being expanded into Table 2, Differences between ‘economic’ and ‘real’ people. Table 2 is based on paper presented by a professor of psychology (Wearing 1973). From Table 1 it will be noted that the cash-flow method extends the features of the profit paradigm and in other areas it replaces them as it does for all points in Table 2. In this way the cash-flow approach results in “handling the same bundle of data as before, but placing them in a new system of relations with one another by giving them a different framework” (Kuhn 1980: 85). Tables 1 and 2 provide a way to compare and evaluate the two paradigms to support the observation of. Kuhn (1970: 77) who stated that "The decision to reject one paradigm is always simultaneously the decision to accept another, and the judgment leading to that decision involves the comparison of both paradigms with nature and with each other". The Tables provide a way for readers not only how to compare each paradigm with each other but also with nature. For example in row 5 of Table 2 it is noted that humans can be competitive and/or cooperative. The need for all social animals to have such contrary characteristics and/or being self-interested/altruistic and/or suspicious/trusting and so on can be explained by evolution developing this as a strategy for economizing the volume of data that they need to receive, store, process and transmit to sustain their existence. The emergence of such contrary characteristics in biota and their social structures is described as “social tensegrity” (Turnbull 2000b: 134). This is because it provides the maximum amount of control with a limited amount of data in a similar way biological structures constructed with components of contrary physical characteristics provide the greatest amount of strength with a limited amount of material (Ingber 1988: 32). The importance of facilitating social tensegrity in the design of social institutions is that it introduces checks and balances to provide an efficient basis for achieving sustainable self-regulation and self-governance. The ability of communities, regions, provinces and nation States to become self-governing depends upon their ability to become financially independent to be free of external political and/or management interference. The cash-flow paradigm provides the intellectual tools for introducing self-financing development discussed in Section 5. But first there is a need to introduce words that provide greater precision in describing the nature of assets and the processes for creating wealth as is next considered. 6

Grounding economics in commercial reality: A Cash-flow Paradigm Table 1, Differences between Profit and Cash-flow Paradigms

Area of difference

Profit paradigm

Cash-flow paradigm (Holistic economics)

1

Activities which provide the basis for formal economic study

Production and exchange of goods and services

Production and exchange of goods and services and the transformation and exchange of assets and liabilities

2

Sources of increased production or productivity

Principally labour

Principally machines, structures and organisations

3

Sources of private economic value.

Production

Production, tenure and consumption

4

Social objectives

Full employment, higher standards of living

Economic independence, personal fulfillment

5

Criteria for resource allocation

Profit

Cash-flow

6

Notion of 'Capital Goods'

Various, imprecise and confusing, e.g. 'Income producing assets', 'Produced means of production'.

The means by which nature is made to yield her resources more abundantly - evidenced by producing a positive cash-flow

7

Real capital formation

Past savings or consumption forgone

Past savings or future savings and new consumption

8

Basis for economic management

Monetary and fiscal policies

Monetary, fiscal and tenure policies based on ecological principles

9

Concept of wealth

Various and conflicting, e.g. 'Income', 'Income producing ability'.

Value of assets less liabilities

10

Criteria for economic development

Increased income per person

Increase in the quality of the sustainable social and/or physical environment

11

Structure of: money, banking, corporations, ownership & control

Assumed not to vary from some Based on current reality which may unspecified model be subject to continuous changes

12

Human behaviour

Assumed model (Refer to Table Based on psychological profile 2) (Refer to Table 2)

7

Grounding economics in commercial reality: A Cash-flow Paradigm Table 2, Differences between 'economic' and 'real' people Table adapted from one prepared by a Melbourne University Professor of Psychology (Wearing 1973) 'Economic' people

'Real' people

1

Unlimited appetite

Appetite determined and limited by the necessity of maintaining the organism in a state of dynamic equilibrium.

2

Completely informed

Reduces, condenses, summarises (and thus necessarily loses) information, in addition, an 'imperfect' communications network in the environment also restricts and attenuates the flow of information

3

Consistently orders his/her preferences between outcomes over time.

Does not consistently order his/her preferences (i.e., changes his/her mind over time, may prefer A to B, B to C but C to A.

4

Maximises something (usually one thing).

Attempts to optimise with respect to a large number of criteria (needs).

5

Competitive

Sometimes competitive, sometimes collaborative; usually both.

6

Requires a value system only in order to provide a criterion against which to maximise, e.g. profit, utility, prestige, power.

Requires a value system in order to provide a framework for the ordering of needs, the selection of information and the weighing of multiple decision criteria.

7

Not explicitly related to the world as Stands in an interactive cybernetic relationship to his/her an element in interactive system and community and environment, and is changed as a result of remains unchanged as a result of any interaction. any interaction.

8

No significant differences between individuals.

9

No limits on information processing Limited information processing capacity so prefers slow capacity, so is unaffected by rates of change, i.e. nearly stable systems. differences in rates of change.

10 Needs are simple and few

Differences between individuals are significant and important.

Needs are simple and many

3. The nature of wealth and how it is created. The section identifies and categorizes various types of assets with represent wealth or are involved in its creation consistent with the observation concerning new paradigms that “We need a new vocabulary and concepts for analyzing” (Kuhn 1980: 55). A classification of various types of assets is presented in Figure 2, The nature of wealth. 8

Grounding economics in commercial reality: A Cash-flow Paradigm Figure 2, The nature of wealth.

Wealth = Assets less liabilities

Character

Economic status Type

Passive or degenerative Assets

Financial Assets

Description Money Time scale Examples

Value change Income

Debt

Undefinable Normally limited to 50 years Coin Bank deposits Notes Other things Debentures Cost of Ins. Nil without & storage. inflation None Interest

Procreative Assets*

Real Assets#

Equity

Natural

Real

Degenerate Durable Fabricated Fabricated

Time limited Enduring ReDepletableConsumable Generally except most generative (transient) wear-out corporations (periodic) Shares, Life Land Cattle Minerals Food Whitegoods assurance WaterForrest Oil Fuel Furniture ways Crops Gas Clothing Collectibles Usually Often Usually Positive Negative Most positive positive positive generically degenerate Dividends & Rents Sales, fees Sales None Minimal Profit shares Royalties Royalties

* Source of increases in living standards

#

Intang.

Wears out

Time Limited

Tools Patents Machines Trademarks Structures Copyright Depends on Obsoloperations escence Sales Royalties Rents

Reflection of higher living standards

Figure 2 adopts the commercial definition of wealth which is the value of assets minus liabilities as noted in row 9 of Table 1. It identifies various types of real, financial and intangible assets and describes their characteristics. The importance of Figure 3 is that it identifies those assets which (i) create wealth to raise living standards, i.e. “*Procreative assets”, (ii) assets which provide a better standard of living but consume wealth rather than generate wealth, i.e. “#Real assets” and (iii) assets that were intended to create wealth but failed to do so to become “degenerative” assets. A degenerative asset for example could be a patent and/or machine to make a widget that nobody wants or does not become commercially viable. The test of whether an asset creates or consumes wealth is if it can be used to produce goods and/or services that generate cash-flows that are in excess of all its costs before transfer payments of interest and taxes over its operating life. All other costs are those involved in the creation or purchase of the assets and those incurred from its operations. To quote Moulton (1935: 10−11) "We are interested in the processes by which society expands its power to make nature yields its resources more abundantly; and from this point of view we are concerned with procreative property". Procreative assets must by definition become self-financing as noted in row 6 of Table 1. For public policy reasons it is important to note that taxes and interest costs associated with the operation of procreative assets might mean in practice mean that they do not become self-financing for the owner and so would fail to become commercially viable.

9

Grounding economics in commercial reality: A Cash-flow Paradigm Procreative assets can be tools, patents, machines, structures and organisations which over their operating lifetime, produce goods and/or services with a value greater than the cost of creating or acquiring the asset and the cost of its operations, excluding tax and interest charges. The additional value generated in excess of all costs over the life of procreative asset will be defined as “Surplus Value”. As reported by Freedman (1976), Marx also used the term “surplus value” but it was not necessarily based on the involvement of procreative assets. As defined here the term surplus value represents the value of the increased output from productivity improvements. Procreative assets provide the only way to increase productivity without humans working harder or longer hours. Because surplus value can be measured only over the useful life of an asset, it is different from the Marxist concept which is based on accounting profits, which Marx viewed as being created by people rather than by assets. However, the cash-flow concept of surplus value is similar in the sense that it "is the source of capitalist profit" (Freedman 1976: 70). As is discussed in Section 6, part of the "capitalist profit" or surplus value may represent a "surplus profit". This is a unique contribution of the cash-flow paradigm being the ex-post cash-flows in excess of the ex-ante incentive to bring forth an investment in a procreative or any other type of asset. Surplus value in the cash-flow paradigm could be described as a "free lunch", an outcome denied by many economists. However, Rostow (1978: 48) has estimated that in the 200 years after the American Revolution in 1776 the volume of manufactured goods in the US increased seventeen hundred times. This did not occur from people working with more effort or through working longer hours. Indeed, over the period the average working hours per week was almost halved. So the increase in output per working hour must have been well in excess of 1700%. This was not achieved by people worker harder but through the use of technology embedded in procreative assets. The evidence of history proves that there are such things as free lunches, and moreover, they can be very substantial. This is why procreative assets can be described as the engines of economic growth. It is only by generating surplus values that the standard of living can be increased without people working harder or for longer hours or relying on external trade. The words 'capital' 'real capital', 'income producing assets' or 'produced means of production' as used by economists may describe procreative assets but they could also describe assets, which use up/absorb economic values. All fabricated assets shown in Figure 3, which do not become procreative, become “degenerate assets” as they absorb more value than they produce. However, many degenerative assets are consumer durables, which improve the quality of life and/or the standard of living. This class of degenerate assets is referred to as “consumption assets”. Consumer durables represent an improved quality of life/standard of living, but they do not generate it. These distinctions are vital for the efficient and effective design and management of economic development institutions. This is because development depends upon the surplus values generated by procreative assets being as least as valuable as the values absorbed by degenerate assets in much the same way that the wealth of company does not increase unless the values created in one part of the business offset the values lost or absorbed in other parts. Some consumption assets may even produce income, but not sufficient to make them self-financing from their operations to add surplus values to society. A home may provide an example in this regard. In the profit paradigm, the value of the "service" provided by a house may be recognized in the form of an imputed rent. The use of such artificial and non-realistic concepts introduced to justify a theory of 10

Grounding economics in commercial reality: A Cash-flow Paradigm economic rent can obscure practical economic processes. They can be avoided by grounding economic analysis in cash-flows. The classifications introduced above and shown in Figure 1 provide a basis to analyze the different social results from owning different types of assets. For example, consider the social consequences of owing a procreative asset such as a long haulage truck or a dwelling costing the same value. The truck will pay for itself and the cost of a hired driver over a period of typically five years and then generate income over its useful life to “keep” its owner – with surplus values. The owner of a house may have to work for thirty years to pay off a mortgage “keep” her/his house. The difference is that a procreative asset liberates the owner from work while degenerate assets enslave their owner into working (unless she/he also owns income-producing assets). If we are interested in improving the quality of life of society then we need to know the implications of owning various types of assets. This possibility is denied by the profit paradigm where ownership does not matter for many leading economists. According to a survey of 'mainstream' economists made by Brittan (1975: 51), "....the key to success is not ownership but freely operating competitive markets, which can also be envisaged in a socialist economy where enterprises are state-owned." The problems created by the words and concepts of orthodox economic analysis need to be identified to illustrate the power of the cash-flow approach for making the world a better place. These are considered in the following section. 4. What do economist’s mean when they talk about Capital? Consider the statement by Heilbronner & Thurow (1984) in their economic text book The Economic Problem: "What is capital? It is wealth that can be used to create still more wealth. The humblest commodities can be capital as well as the most dazzling jewels, as long as they can be sold to gain still more wealth". The ability to sell an asset to gain wealth/income/cash-flow is irrelevant to the definition of procreative assets. To be procreative, the cash-flows must arise from the operations of the asset, not by its disposal or contingent sale (transformation of ownership rights) through using it as security for a loan. In addition, many assets such as jewels and commodities are not man-made. Procreative assets increase productivity because of the technology embedded in them when they were made or in the way they are used. Procreative assets represent intelligence and know-how, which allow people to work in a more efficient way rather than work harder. It might be said that procreative assets contain what Marx described as “congealed labour value” and so the result of exploited labour. In the cash-flow paradigm surplus value is seen as arising from the technology imbedded in machines and organizations, for which people have already been paid, to allow “nature to yield her resources more abundantly” (Moulton 1935: 11) Wealth in the form of income in the profit paradigm might indeed be obtained from the sale of commodities and other assets at a price greater than their cost. But this might not be due to the generation of surplus values. As noted earlier, we need to make a distinction between the generation of wealth through the creation of surplus values as distinct from obtaining increased income and/or net asset value through the manipulation of property rights and obligations. The distinction is vital to analyse the contribution made to society by paper entrepreneurs, corporate raiders or property and commodity speculators. The accumulation of wealth through the transformation and exchange of 11

Grounding economics in commercial reality: A Cash-flow Paradigm property rights and obligations is dependent upon capturing wealth generated or held by others as considered further in Section 7. The different and muddled thinking of economic text books is illustrated by comparing Heilbronner & Thurow (1984) with Samuelson (1970: 48) who requires “capital goods” to be man made. He states, "Capital goods, then, represent produced goods that can be used as factor inputs for further production…" However, the irrelevancy of his description of “capital goods” as a means of generating wealth or for even increasing income is illustrated when he states: It should be pointed out that the government does own a good deal of the national real capital, e.g. Hoover Dam and submarines. In addition, its agencies such as the Federal Housing Administration (FHA) and the Small Business Administration (SBA) are important sources of capital loans for home-owners and private business".

The Hoover Dam might well be procreative but submarines are certainly not. Submarines do not create wealth. They are built to destroy wealth. To build a submarine, productive capacity and so wealth must be used up. Thus, even if submarines are not used for destructive purposes their creation will absorb wealth and so depress the standard of living. In the above quotation, Samuelson also suggests that loans are capital. This is another reason why the word capital is unacceptable for rigorous analysis of wealth generation. The reason why economists describe non-productive assets such as submarines and jewels as items of capital is because they define physical capital formation to be investment. Investment is defined to be production of goods, which are not immediately consumed and so represent "savings". The nature of the goods may not be a concern to traditional economists. Goods not immediately consumed are described as capital goods whether or not they are procreative assets or non-productive degenerate assets such as submarines or income-producing assets like housing which may not obtain sufficient income to become procreative. Traditional economists have been concerned only about the rate at which goods are produced or consumed, not their ability to generate or absorb wealth/cash-flows. It is this latter feature which is a major concern for business people and households and supports the need for grounding economics in commercial reality. Because economists do not differentiate between the various types of assets there is considerable room for differences of opinion as to how wealth and so economic development is created. This has produced much controversy between economists over various competing theories of capital formation, economic growth and development such as considered by Blaug (1974). Economists had difficulty in convincing themselves that they understand the mechanisms of economic growth. Commercial practitioners have no such difficulty. Samuelson (1970) is conscious of these shortcomings in economic theory. He reproduces the quote paraphrased from Lord Kelvin who said: "When you can measure what you are speaking about and express it in numbers, you know something about it; when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science…". Unlike the profits paradigm, the cashflow approach provides a quantitative way for testing which type of asset generates wealth as indicated in row 6 of Table 1. It is interesting to record that thirty-five years earlier, Moulton had a much simpler and clearer discussion over the meaning of the word capital that either Heilbronner & Thurow or Samuelson. As 12

Grounding economics in commercial reality: A Cash-flow Paradigm noted earlier, Moulton saw the need to distinguish "procreative property" from other meanings of the word capital. Moulton also describes the "round about method of capital formation" which is described in the following Section as a “confluent development” process. 5. Economic growth This section considers how the unique ability of procreative assets to generate surplus values can best be used to further economic growth and political independence. The contribution that procreative assets can make to political independence arises from their ability to make economic development selffinancing. Not only must all procreative assets be capable of being self-financing, but they also provide the means for a business, community, region or economy to grow on a self-financing basis. As procreative assets provide the only way to increase output with less labour, the formation of procreative assets provides the only way to improve the quality of life in a community, region or national economy without relying on the export of natural resources. The formation rate of procreative assets is a critical factor for increasing the rate of economic growth and development. Because all procreative assets must be selffinancing, the rate of development cannot be limited by finance, provided the community, region or economy has appropriate banking institutions to produce as much credit as there are opportunities to increase productivity. However, a view has developed by orthodox economists that economic growth is limited by investment and that investment is limited by the availability of savings in the form of money. This view provides the rationale for many current policy initiatives to encourage people to save more and for the establishment of institutions such as the World Bank to redistribute savings and so investment. As savings are defined as unspent income, increases in savings mean that there is less demand for production. This in turn reduces the incentive for investment in productive activities to reduce the need for investment and savings. A “contrary development” process is created from increased savings reducing both the need and incentive for making new investment in procreative assets to raise living standards. A stop-go process is produced to promote a business cycle. The conceptual problem is created and/or is reinforced by associating the word “saving” with the idea of consuming less today rather than in future. In the future, higher income can be achieved from the surplus values produced from investments in procreative assets so as to allow savings to be achieved without the need to reduce consumption today. In other words investment consumption, production and savings can all increase together to create a “confluent development” process. A virtuous selfreinforcing development process is created instead of a self-limiting contrary process. A confluent development process also accelerates economic growth and development because it avoids the need for a community, region or nation state to use external debt or equity to finance its development. The transfer of surplus values to external agents can drain out of a community, region of nation State a substantial part of any surplus values generated by procreative assets. If a development project is to become self-financing to pay back an external source of finance then it must also become self-financing to pay back a domestic source of funding. Another reason why it makes no sense for countries to use foreign borrowings to finance domestic development projects that need local currency as it is only their own banking system that can create its domestic currency. Internal financing also 13

Grounding economics in commercial reality: A Cash-flow Paradigm eliminates the need to export foreign exchange to service external funding sources. There are various ways in which nations have achieve a self-financing, "pulling your-self up by the bootstraps" confluent development process. Moulton (1935) describes how the US became self-financing early in the 20th century by its commercial banks producing credit to finance investment banks to acquire new shares issued by corporations to finance their expansion. This allowed the US to change from being an importer of financial credits at the end of the 19th century to being an exporter at the beginning of 20th century. The US lost the ability to finance its growth by this means when commercial banks were forbidden to finance investment banks by the 1933 Glass-Steagall Act and the centralization and monopolization of credit creation through amendments to the Federal Reserve Bank Act of 1934. Moulton explains how the investment banks acted like loan insurers for the commercial banks who created credits by making loans to them. The loans were secured by a portfolio of shares which the investment banks held in a number of businesses in different stages of development in different industries in different locations until the shares could be sold on a stock-exchange to pay back the loans. In this way, the risk of shares not being sold to provide liquidity was averaged out over industries, over time and across the nation. Japan and Germany also achieved financial independence at the beginning of the 20th century in similar sort of way through a process described by Ehrlich (1957: 469) as “over-loaning” by their commercial banks. The risk of loss by the lending bank was reduced by the equity base of well established associated network of industrial shareholders in a family group described as a Zaibatsu in Japan. A somewhat similar arrangement was created by commercial banks in Germany with their relationships with their industrial borrowers and cross shareholdings. This explains why today the system of corporate finance and governance in Japan and Germany is different from that of the US as described by Porter (1992). The same sort of risk sharing over time and industries was achieved by quite a different means with the establishment of over 200 worker co-operatives that began to form in 1956 around the town of Mondragon in the Basque region of Northern Spain. However, the Mondragón process did not involve a confluent development process as new investment was financed from accumulated savings rather than from creating credit to finance the investment. However, Mondragón illustrate the self-financing principle of economic development and how this in amplified by local ownership. New firms were not established with equity investment from families, venture capital corporations or institutions but by loans from the “Empresarial” division of a bank owned by all the cooperatives. The Bank, known as the Caja Laboral Popular (CLP) was created by the cooperatives to finance new firms, many of whom where spin-offs from their own operations to keep the size of firms to human scale. The hundreds of firms created by the bank are both its owners and core customers. The cooperatives now have over 60,000 workers (MCC 2005) with the CLP becoming one of the largest Banks in Spain. The Empresarial Division of the CLP was described by Ellerman (1982) as a “factory factory” and became a separate firm in 1987. Like the US investment banks early in the 20th century this firm averaged the risk of business failure over many firms in many industries in different locations and in different stages of development. While over 75% of capitalistic start-ups typically fail in their first five years of operations only a few have at Mondragón. A World Bank study (Thomas & Logan, 1982) 14

Grounding economics in commercial reality: A Cash-flow Paradigm reported that: During more than two decades a considerable number of cooperative factories have functioned at a level equal to or superior in efficiency to that of capitalist enterprises. The compatibility question in this case has been solved without doubt. Efficiency in terms of the use made of scarce resources has been higher in cooperatives; their growth record of sales, exports and employment, under both favorable and adverse economic conditions, has been superior to that of capitalist enterprises.

The outstanding performance of Mondragón firms could in a large degree be attributed to how they are management with their highly democratic and participative processes that are integrated into their unique governance architecture described by Turnbull (1995). As all firms are locally owned and controlled they maximise their ability to be self-governing units in the Mondragón system. Selfgovernance has been an important political agenda in this largely Basque region of Spain that has been seeking independence from the central government. But local ownership and control also provides an important source of economic performance by minimizing the export of value from the region in the form of interest and dividend payments. It eliminates what Penrose (1956) described as "unlimited, unknown and uncontrollable foreign liabilities”. By this means it eliminates the export of cash-flows in excess of the incentive to bring forth equity investments described as surplus profits that are next considered. 6. Surplus Profits The Section introduces a new concept to economic discourse and analysis described as “surplus profits”. Surplus profits represent a surplus incentive to invest in productive activities or acquire other assets. As shown in Turnbull (1992), surplus profits are not trivial and can introduce significant distortions in the operations of private property market economies. Surplus profits create inefficiency and inequities that cannot be understood with the current intellectual tools of orthodox economic analysis. Some problems are not even detected with traditional methods of analysis. For example, how investors can be overpaid, and so how foreign investment can be counterproductive for host countries. This blind spot is consistent with the observation by Kuhn (1980: 24) who stated that “No part of the aim of normal science is to call forth new sorts of phenomena; indeed those that will not fit the box are often not seen at all” (emphasis added). The term “surplus profits” is not to be confused with the concept of “economic rent” as it is different from the many ways the term “economic rent” is defined or used. The term “economic rent”, like other concepts in the profit paradigm, can have various meanings. The meaning of “economic rent” has changed over the years as described in Wikipedia . A Google search reveals a dozen different contemporary definitions with many involving contingent, hypothetical or even “unknowable” sources of cash-flows that can arise from “opportunity costs” and alternative uses. A common contemporary definition of economic rent is “a payment to a factor of production or input in excess of that which is needed to keep it employed in current use”. The use of the term in this way describes what may be described colloquially as “Excessive profits”. This meaning of economic rent is quite different from the concept of surplus profits that are not concerned about keeping a productive 15

Grounding economics in commercial reality: A Cash-flow Paradigm asset “employed in current use” as referred to in the definition. Nor are surplus profits concerned about keeping assets in any other use. By definition surplus profits can not be used to motivate activities and so uniquely explains markets failure to efficiently allocate economic value to achieve the greatest good for the greatest number. The concept of “economic rent” is used to explain the motivation to acquire or create a productive asset to produce goods or services. However, surplus profit can not provide the incentive to buy or build productive assets as they are the cash-flows in excess of the incentive for making an investment. Surplus profits are the excess incentive, or cash-flows, that arise beyond those required to motivate the acquisition of a productive or other asset or bring them into existence. The incentive to acquire or bring productive assets into existence is based on profits that can be achieved before surplus profits arise. The concept of economic rent in the form of an excessive profit is used by economists to explain how market forces will encourage demand to be met by consumption, absent monopoly or other trading privileges. It is possible for excess profits to become surplus profits when they continue for a period beyond the investor’s time horizon but surplus profits can never become “economic rent” in the way it is variously defined. Another reason why traditional economists do not learn about surplus profits is because they are not reported by accountants. Accounting doctrines do not require investment time horizons to be identified2. Surplus profits only arise after the investor’s time horizon and this typically involves a number of accounting periods. Accounting profits are estimated within an accounting period. Any profits judged to be “excessive” are likewise related to a specific accounting period to illustrate how these are not related to the concept of surplus profits. Indeed, excessive profits can arise without surplus profits and surplus profits can arise without excessive profits or any previous profit if these do not emerge until after the investor’s time horizon. It is also possible for surplus profits to arise even if the asset does not become self-financing or meet the test of becoming procreative to contribute surplus values. Unexpected windfall gains represent surplus profits and these can arise from many different types’ of property rights like, art, artifacts and housing considered in the next Section. Accounting profits for firms with productive assets are determined by making a guess3 on how long the assets may operate as accounting doctrines require the cost of wearing out the asset to be apportioned over its expected useful life. For this reason, even historical cost accounting requires accountants to become fortune tellers to determine current profits. It also means that publicly traded enterprises can report profits even though their productive assets may later create a cash-flow loss from being scraped prematurely from changes in market demand for their output, technological obsolescence, or damage as discussed in Turnbull (1975b).

2

Investment time horizons may be reported when the discounted value of future cash-flows from intangible assets are presented to justify their book value. 3 There is no need for guessing the life of productive assets in a cash-flow accounting system that records all expenditures as a cost no matter how long any productive assets may operate (Turnbull 1979).

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Grounding economics in commercial reality: A Cash-flow Paradigm Figure 3, Surplus Profits With a ten year investment time horizon and a twenty year operating life for a $100 million investment depreciated over the 10 year time horizon

$100 million investment with ten year investment time horizon and 20 year life Earnings before depreciation and tax Depreciation Earnings before tax Tax at 36% Profit after tax Cash return Accounting return Surplus profit Discounted Cash Flow return (DCF)

YEARS 0-10 Millions p.a. $41.25 $10.00 $31.25 $11.25 $20.00 $30.00 20% $0.00 27.3%

YEARS 11-20 Millions p.a. $41.25 $0.00 $41.25 $14.85 $26.40 $26.40 26.4% $264.00

Even when productive assets have an operating life of 30 years or longer, as often occurs for major projects, the time horizon used for deciding if to invest in such assets can be very much less (Turnbull 1992). This is because of the practice of discounting the value of future cash-flows at the investor’s 17

Grounding economics in commercial reality: A Cash-flow Paradigm opportunity rate to invest elsewhere. With equity opportunity rates of 20% or more the value of future cash after 10 years is greatly reduced (Turnbull 2000a). Because of the risk of changing market demands, technology, management and other operating risks the value of future cash flows are discounted again to produce investment time horizons less than 10 years. The greater the perceived risk then the shorter becomes the time horizon with venture capitalists using horizons of less than three years. Unless future revenues have protection from risk with political privileges, commercial time horizons for domestic investment are normally less than 10 years. Ten years is a common limit for international investments which introduce additional foreign exchange, social and political risks. As a general rule one may conclude that any returns remitted from a host country to foreign investors after ten years represents the payment of surplus profits. In other words, countries that do not place sunset clauses on foreign equity property rights are over paying investors and unnecessarily exporting foreign exchange and reducing the incomes of residents. This could be described as economic vandalism. Yet is occurs on a grand scale throughout the world because of the limited remit of orthodox economic analysis and its concerns. Surplus profits are not exceptional or insignificant. Figure 3 reveals how surplus profits in the example can exceed the after tax profit providing the incentive for the investment to be made by being 2.64 times the value of the investment that produced an aggregate accounting after tax profit 2 times the investment cost. This indicates how local ownership and control of the means of production and exchanges as practiced by Mondragón firms can capture and re-circulate surplus profits to generate superior performance. Some may argue that any such "windfall" or "unexpected" profits arising after the time horizon are not surplus as they are needed to offset losses made on other investments. But the cost of such losses are already factored into the rate of return ("hurdle" or "target" rate) required from investments within the chosen time horizon. Because by definition, surplus profits are not taken into account in investment evaluation, they cannot be allocated a priori to cross subsidy investments, which do not perform. The existence of surplus profits is largely denied by the existing paradigm, which assumes that market forces will eliminate any “excessive” profits when monopoly rights or privileges to provide goods or services are absent. The reason that market forces do not eliminate surplus profits in the absence of privileged trading rights is that market economies accept a system of monopoly ownership rights, which can shut out market forces for ownership4. Not only do market economies provide exclusive (monopoly) ownership rights over real assets but they are provided on a static perpetual basis. In comparison, all property rights to intangible assets, such as patents and copyright, are provided on a time limited basis as noted in Figure 2. There is not a level playing field between real and intangible assets. Millions of dollars can be expended in obtaining a patent whose property rights could be limited to 20 years. Many patents do 4

An exception could exist when ownership rights to procreative assets are held by a corporation that is publicly traded without a dominant shareholder to allow a market for corporate control to exist.

18

Grounding economics in commercial reality: A Cash-flow Paradigm not yield any return cash-flow or cash-flows sufficient to recover their cost and so do not become procreative. This is why there is horizontal line from the intangible assets on the right hand side of Figure 2 to indicate that intangible assets can be “degenerative”. To achieve economic growth the surplus values from procreative assets and exports need to exceed the aggregate of all consumption assets produced combined with all degenerate values produced from productive assets that did not become procreative in a given period. As noted earlier, procreative assets that do not become commercially viable by becoming self-financing can still contribute surplus values to the economy through transfer payment of interest and taxes. To ameliorate the problem of overpaying investors with surplus profits, they could be distributed to the agents involved in their creation. As no business can exist without employees, customers, suppliers and host community, surplus values could not be created without their involvement. Distribution of surplus values to these primary stakeholders could be achieved by replacing the current static, perpetual and exclusive system of property rights to realty and corporations with dynamic, time limited and inclusive property rights. The nature of these property rights are outlined in Turnbull (1992) that was written to explain the theoretical framework of Democratising the wealth of nations (Turnbull 1975a). The book describes how the resulting institutional changes would improve capitalism to create a more efficient and equitable architecture described as “Social Capitalism”. The concept of surplus profits provides the key for understanding an important shortcoming in the current form of capitalism5. It identifies how wealth inequality is created from investors being overpaid be they foreigners or local citizens. Another source of inequality and inefficiency is windfall gains created from asset ownership, especially when public investment in urban infrastructure creates windfall gains in owning realty. This problem is considered in the following Section. 7. Windfall Gains and Wipe-outs The Sections considers the surplus values crated from owning assets that may not be procreative or even generate an income such as art, artifacts, collectibles, housing and vacant land. The market value of such assets may increase or decrease from changes in demand that may have nothing to do with the owner and are referred to as respectively as “windfall gains” or “wipeouts”. As balance sheets are required to identify and analyse windfall gains and wipeout, they are ignored by economists constrained by the limited remit of the profit paradigm to the production and exchange of goods and services. For example when economists analyse the cost of providing low cost housing they concern themselves only with house prices, welfare payments, taxes and rents, not changes in land values in the area or the value of infrastructure investments which create the value in urban sites with services like water, power, roads, sewerage, transport, schools, hospitals, places of employment and recreation. The ability to provide sustainable low cost housing on a sustainable, replicable basis is hidden from policy makers using the limited remit of orthodox economic analysis (Turnbull 2006). An example of how urban public infrastructure could be made self-financing is provided by the building of the Jubilee underground line in London. The uplift in land values within 1,000 yards of each of the eleven new stations built in 1999 totaled £sg13 billion (Riley 2002). The cost of building 5

Other short-comings are identified in “The seven deadly sins of capitalism” (Turnbull 2002).

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Grounding economics in commercial reality: A Cash-flow Paradigm the line was only £sg3.5 billion. An example of how public investment could become locally selffinancing if a different system of property rights was introduced described as a Co-operative Land Bank (CLB) is described in the following Section. As indicated by Riley, the extent of windfall gains and wipeouts in the economy can be substantial to create major distortions in the efficient operation of a market economy. An inspection of the balance sheets of publicly listed corporations in Australia reveals that for many, their wealth arises more from revaluation of their realty then from accumulated profits (Turnbull 1992). A notable example of how foreign corporations can extract surplus profits from a host country is illustrated by the investment of the US based General Motors Corporations (GMC) in Australia. The expansion of the subsidiary from a vehicle assembler in 1926 to a manufacturer in 1945 was mostly financed through windfall gains (Turnbull 1973). It was the windfall gains obtained from its land holdings in a rapidly growing suburb of Melbourne that provided the basis for a major capitalization of the company through the issue of free bonus shares to its parent company. Only A£0.5 million had been invested in the company by 1945 and no further common shares had been issued for cash yet 15 years later, the dividends remitted to GMC each year was 200% greater than the cash subscribed to set up the investment. This is an example of surplus profits and how they can reduce income received by residents and drain away foreign exchange reserves without the country obtaining fair value in exchange. The size of the dividend remittances became a political concern, as the company was a monopoly producer sheltered by high tariffs. As a cosmetic political maneuver, the company increased by a factor of around ten times, the value of its shares on issue in 1967. This reduced the ratio of dividend value to shares on issue by a factor of 10 to produce a much more politically acceptable return of around 20%. The ability of the Australian subsidiary to issue the free bonus shares was created from windfall gains in the value of the land owned by the company. These increments in value were not created by the company but by would be Australian home owners bidding up the value of urban land. An example of how markets forces do not promote either efficiency or equity. The degree to which surplus profits are supported and compounded by windfall profits is illustrated by the book value of the GMC subsidiary reaching A$200 million in 1974 after it had paid dividends of A$250 million to GMC. In addition the subsidiary was still able to report that its book value had in risen to over A$200 million. The capture of such excessive profits is only possible because of the rules used by society for owning land and corporations. More efficient and equitable rules are required to eliminate the "unlimited, unknown and uncontrollable foreign liabilities" identified by Penrose (1957). However, the problem is not just a concern for foreign investment. The same inefficiencies and inequities exist in all domestic investments based on static, monopoly, perpetual ownership rights. A solution is to adopt dynamic, co-ownership; time limited rules which follow the principles of nature outlined in Turnbull (1992). Windfall gains are also widely utilised by privately held companies to finance their growth. Yet this vital economic phenomenon is invisible to people who use the profit paradigm as the basis for economic analysis. Windfall gains are especially important in a country like Australia where average land values in many urban municipalities has increased at a compound rate of over 20% pa. for a quarter of a century. This means that land valued at $1 million would become worth over $500 million during this period in a country which only introduced capital gains tax for assets purchases after 1985. 20

Grounding economics in commercial reality: A Cash-flow Paradigm The problem of windfall gains in land values is shared by other countries. Kennedy (1988) points out that the value of urban land in the Federal Republic of Germany rose three times faster than wages from 1950 to 1982. Windfall profits arise from the transfer of value without necessarily generating any increase in the ability to produce more goods and services. Consumer demand for the use of the property by nonowners can create windfall gains for the owners. In this way the existing system of property rights provides a way of transferring wealth from the poor and/or the productive, who may not own property, to the rich who own property and may not be productive. Inflation compounds the concentration of wealth as described by Turnbull (1975a: 41−5). Solutions to this problem using the existing paradigm are limited to the introduction of taxes to transfer back the values captured by property owners. The proposals of Henry George (1980) provide an example in this regard. A cash-flow paradigm would have provided both George and Marx new solutions for the problems, which concerned them. Most taxes introduce disincentives and distortions and increase the power and cost of government. The cash-flow paradigm allows solutions to be introduced which not only allow these costs to be minimised but which more importantly, correct the fundamental problem inherent in the current system of property rights. It is the rules for owning land and buildings, which create the problem. Taxes only address the adverse effect, not the cause of the problem. A better approach is to adopt more efficient and equitable rules for owning things. Rules that replace the current static, monopoly perpetual rights with dynamic, co-ownership time limited rights as proposed in the next Section that considers some policy implications. 8. Policy implications of a cash-flow paradigm This Section considers a couple of the many policy implications of using a holistic analysis of economic activities to illustrate how it provides intellectual tools to improved the efficiency and equity of capitalism in quite fundamental ways. Specifically, how: (i) the concept of surplus profits can be used to adopt policies for their mitigation by their transfer to citizens without the need for introducing the dead weight cost of taxation and welfare and (ii) the concept of procreative assets can be used to adopt policies to accelerate economic growth to provide financial independence of citizens, communities, regions and nation states to further their political independence. Instead of taxing surplus profits, be they arise from procreative assets or windfall gains arising from the ownership of realty; there exists the option of changing the rules of ownership to introduce private sector transfers of wealth using dynamic property rights. In this way direct involvement of the government could be avoided to minimise its size and the cost of government. Government involvement would still be required but on an indirect basis as proposed by Gore (1996) of “imprinting the DNA” of social institutions. Governments could use fiscal, monetary and/or other types of incentives to make it more attractive to investors to obtain quicker, bigger, less risky short term cashflow returns in exchange for relinquishing ownership over the longer term from which they would obtain smaller, slower and more risky cash-flows. The tax incentive required to make it attractive for shareholders of existing firms to change their constitutions to distribute ownership and so surplus profits to their stakeholders to create “Ownership Transfer Corporations” (OTCs) is set out in Turnbull (1975a: Appendix; 1992; 2000a). Imprinting the DNA of firms in Mondragón is achieved by the CLP that makes it a condition of providing start up 21

Grounding economics in commercial reality: A Cash-flow Paradigm finance that the constitution of the firm being supported introduces a division of power to introduce both self-governance and the manner in which surplus values are shared with stakeholders (Turnbull 1995). The distribution of surplus profits from the windfall gains created in realty can be distributed without taxes by establishing a “duplex” tenure system (Turnbull 1992). It is described as a duplex ownership and control system as it creates two separate negotiable property rights. One “title deed” provides ownership and control of a specific building on a land site and the other “title deed” is related to the economic value of the site. The attraction of this system for commercial investors is that they can substantially reduce the value of their investment as they do not have to purchase any land sites. In return, ownership of their investment is transferred to the community at the rate the investment is written off for tax purposes. As the purpose of depreciation cash-flows are to pay the cost of replacing an investment the rate of profit reported by the investor is not changed even though ownership of the investment is transferred to the community. Only voters residing in the precinct as home owners or tenants can own shares in the company that owns all the land in the precinct. The land owning company becomes a local government body described as a Community Land Bank (CLB) (Turnbull 1983; 1992; 2006). In this way the residual value of all commercial developments in a CLB together with the uplift in site values created by either private or public sector infrastructure investment can only be owned and controlled by residents. No surplus profits in the form of windfall gains can be exported to corporations or external owners. This enhances the ability of CLBs to become a self-financing unit of local government. By eliminating the export of surplus profits from their precinct, CLBs also eliminate the export of surplus profits from their host city, region and nation to enrich the wealth of each component of society. The potential for CLBs to become self-financing is indicated by the uplift in land values captured by GMH and those created by the Jubilee underground line discussed earlier. The self-financing ability of CLBs is enhanced when its residents are also stakeholders in OTCs to capture the surplus profits of firms. Both CLBs and OTCs provide a way to stop surplus profits being drained out of communities, suburbs, cities, regions and national economies to accelerate increases in living standards. As indicated by the above considerations, there is considerable scope for the benefits any economic development policies or initiatives to be exported from the intended beneficiaries if surplus profits are not captured. Indeed, it might well be possible for more value to be exported from a community then is retained within the community as indicated by the development experience of some countries. The take home message is that ownership matters and that when development initiatives are being planned it is important to introduce mechanisms like OTCs and CLBs to prevent development values being drained away. Inherent in the concept of a procreative asset is a mechanism to both create and localize wealth. This is because procreative assets by definition must become self-financing. Any individual, trust, organization, community, town, region or nation can acquire ownership of procreative assets provided they can procure finance to bridge the pay-back period. Any development initiative can then be made dependent upon local ownership and control being established as achieved in Mondragón, management buyouts and by local private equity investors. No private equity investor or corporate raiders can make a profit until their investment has paid for itself and so become self-financing.

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Grounding economics in commercial reality: A Cash-flow Paradigm Mondragón illustrates one technique for “Socialising Entrepreneurship” (Ellerman 1982) to further local economic development. However, as noted above this involved a contrary development process. A confluent development process with new investment financed by future savings it creates can be introduced by using leveraged Employee Stock Ownership Plans (ESOPs), Consumer Stock Ownership Plans (CSOPs) and Universal Stock Ownership Plans (USOPs) as developed in the US by Louis Kelso (Kelso & Hetter 1967). Kelso persuaded the US Congress to promote leveraged share plans with tax incentives in 1976 with the result that today over 10% of all US employees are members of an ESOP. However, the original intention that share plans be based on funding newly created self-financing productive assets has been greatly diminished. The original idea was that a company would fund its growth by issuing new shares to a trust that would borrow all the funds required from a bank. In this way firms could grow without the need for becoming listed on a stock exchange and explains why in the US the majority of ESOPs are with companies not publicly traded. The cash-flows from new self-financing investment acquired by the company would be used to pay back the bank loan. When the loan was repaid the shares would no longer be mortgaged to the bank, and so could be transferred to appropriate stakeholders such as employees, customers and/or suppliers, etc. In this way newly created wealth could be distributed to many rather than being concentrated in the original investors. The tax incentives made it attractive for the original investors to accept any dilution to their equity and provide collateral security for the bank loan. While leveraged share plans distribute surplus profits they do not prohibit investors getting overpaid as achieved by an OTC. OTCs only contribute indirectly to a confluent process when they finance “offspring” enterprises with the assistance of bank borrowings. However, OTCs offer a more tax efficient basis to distribute wealth as the cost of the tax incentives is likely to be less than the increased tax revenues obtained by shifting the tax base from enterprises to individuals (Turnbull 2000a; 2001b). To encourage US banks to finance share plans, they were not taxed on part of the interest that they obtained from their share plans loans. Another incentive, not implemented, was for the Federal Reserve to purchase interest free banks loans advanced to leveraged share plans provided that the loan was fully insured against loss by non-banking institutions with the banks earning a small management fee for handling the loan. In this way the cost of loan insurance would replace the cost of interest to introduce a market mechanism to allocate credit expansion according to the risk of productive assets not becoming self-financing and so procreative. Advanced economies currently have no market mechanism for allocating credit expansion between assets classes. Interest rates are recognised as a “blunt” policy instrument to encourage or discourage aggregate economic activity and so the rate of credit expansion by the banking system. Unless a selective interest rate policy is adopted credit expansion occurs indiscriminately to finance consumption and other degenerate assets to fuel inflation. One problem in adopting a selective interest rate policy is to identify which loans are used to finance procreative assets that increase productivity to reverse inflation and which loans are used to finance consumption and other degenerate assets to exacerbate inflation. This problem and the risk of bank losses is overcome by requiring non-bank institutions to guarantee the repayment of loans used to finance assets that are intended to increase productivity. If the asset fails to become self-financing to provide future savings to cancel the credit created by the banking 23

Grounding economics in commercial reality: A Cash-flow Paradigm system to bring the asset into existence then the credit is cancelled by applying the value of historical savings from the loan insurer. Either way credit expansion is reversed to increase the purchasing power of the currency. The loan insurer takes on the role of investment banks described by Moulton. The proposal to issue interest free credit was considered at a seminar held at the Brookings Institution, Washington, D.C. in September 1977 to consider the Kelso proposal. The moderator of the seminar, Professor Lawrence Klein stated "the expansion of Federal Reserve credit will not be inflationary if the funds made available flow into investment that raises national productivity" (Speiser 1986: 134). The idea of using interest free credits to fund local and state government infrastructure projects was introduced to the US Congress in 2004 (HR 2004). Other ways of organizing and/or obtaining credit insurance for productive assets are described in Turnbull (1986, 1992, 2001c). The rate of economic development of any country depends upon minimizing the export of value through external remittances of rents, royalties, profit shares, dividends and interest. To minimize the export of development values in the form of interest, foreign borrowings need to be minimized. This means that any credits required to mobilize domestic resources should only be produced by the domestic banking system. The need for any foreign borrowings should be limited to the need to obtain foreign exchange to import specialized goods and services required for a development project. The mix of development projects needs to be selected to produce sufficient exports for paying back the foreign exchange. In other words, development needs to be managed so as to be self-financing not only in terms of the local currency but also in terms of foreign exchange6 When external loans are used to create local currency loans to mobilize domestic resources, the host country incurs an obligation to pay interest and pay back foreign exchange when both could be avoided by using its own banking system to produce the credit. The local banking system has to create the local credits in any event so it makes no sense to incur external obligation to make this happen. This reasoning leads to the conclusion that debtor nations of the World Bank should buyback their loans to accelerate their rate of development as described in Turnbull (2001a). Interest payments on long term development loans can result in more than doubling the foreign exchange funds that need to be repaid. In this way external borrowings can inhibit or even reverse development for the host country7. The cash-flow paradigm makes explicit that economic development must by definition be a selffinancing process. This means that the current role of the World Bank and other international development institutions is not optimal and can even be counter productive in furthering client county development. Instead of lending foreign exchange, foreign institutions should be teaching client countries how to make their development self-financing as identified in this paper, the others cited and illustrated in the past by both market and socialist economies.

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A feasibility study for introducing a confluent development process in the Yemen Arabic Republic is described in Turnbull (1992) with the project being self-financing in terms of the domestic currency as well as in foreign exchange. 7 The extent that domestic incomes can be reduced by excessive borrowings in a modern economy like Australia was reported by the Australian Financial Review (1992) that stated "Almost 25% of Australia's export earnings now go overseas in the form of dividend or interest". This was at a time when Australia had the third largest foreign debt in the world with net foreign liabilities representing more than 50% of GDP. Foreign debt has now grown to around 100% of GDP.

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Grounding economics in commercial reality: A Cash-flow Paradigm 8. References Australian Financial Review, 1992, Editorial, p. 16, Wednesday, March 4, Sydney. Blaug, M. 1974, The Cambridge Revolution: Success of Failure? Hobart Paperback No. 6, The Institute of Economic Affairs, London. Brittan, S. 1975, Participation without Politics: An analysis of the nature and the role of markets, Hobart Paper Back Special No. 62, The Institute of Economic Affairs, London. Ehrlich, E.E. 1957, Review of Economics and Statistics, 39:4, Nov., pp. 469-471. Ellerman, D.P. 1982, The socialization of entrepreneurship: The empresarial division of the Caja Laboral Popular, Industrial Co-operative Association, Sommerville, MA. Freedman, R. ed. 1976, Marx on Economics, Penguin Books, England. Galbraith, J.K. 1976, Money: Whence it came, where it went, Penguin Books, England. George, H. 1980, Progress and Poverty, Robert Schalkenbach Foundation, N.Y. Gore, A. 1996, ‘National Partnership for Re-inventing Government’ presented to The Armed Forces Communications and Electronics Association Conference, Virginia, February 13, http://govinfo.library.unt.edu/npr/library/speeches/2702.html. Heilbronner, R.L. and Thurlow, L.C. 1984, The Economic Problem, 7th edition, Prentice Hall, N.Y. HR, 2004, ‘State and Local Government Economic Empowerment Act’, introduced into the House of Representatives of the 108th Congress, May 6, http://thomas.loc.gov/cgibin/query/z?c108:H.R.4310.IH. Ingber, D.E. 1998, ‘The architecture of life’, Scientific American, 30−9, January. Kelso, L.O. and Hetter, P. 1967, Two Factor Theory: The Economics of Reality, Vintage Books, New York. Kennedy, M. 1988, Interest and Inflation free Money, Permakultur Institut e.V. Ginsterweg 5, Germany. Kuhn, T.S. 1970, The Structure of Scientific Revolutions, Second Edition, The Chicago University Press. MCC, 2005, Annual Report, Mondragón Corporación Cooperativa, Mondragón, Spain. Moulton, H. G. 1935, The Formation of Capital, The Institute of Economics, Brookings Institute, Publication No. 59, Washington, D.C. Riley, D. 2002, Taken for a Ride, Centre for Land Policy Studies, London. 25

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Grounding economics in commercial reality: A Cash-flow Paradigm Turnbull, S, 2000a, 'Stakeholder Governance: A cybernetic and property rights analysis', in Corporate Governance: The history of management thought, R.I. Tricker, ed, Ashgate Publishing, pp. 401–13, London, http://cog.kent.edu/lib/turnbull6/turnbull6.html. Turnbull, S. 2000b, ‘The governance of firms controlled by more than one board: Theory development and examples’, A Thesis submitted in fulfillment of the requirements for the degree of Doctor of Philosophy, Macquarie University, Sydney, "http://ssrn.com/abstract=858244" http://ssrn.com/abstract=858244. Turnbull, S. 2001a, ‘Liquidating the World Bank: with debtor countries buying back their loans and introducing self-financing development’, Jubilee Research paper, New Economics Foundation, London, http://www.jubileeresearch.org/opinion/shann_Liquidwb.htm. Turnbull, S. 2001b, ‘The case for introducing stakeholder corporations’, Working Paper, Institute for International Corporate Governance and Accountability, The George Washington University Law School, http://ssrn.com/abstract=436400. Turnbull, S. 2001c, ‘The use of central banks to spread ownership’, presented to Capital Ownership Group, Kent State University, May, http://ssrn.com/abstract=277508. Turnbull, S. 2002, ‘The seven deadly sins of capitalism’ Workers On line, NSW Labor Council Issue No. 147, August 9th, http://workers.labor.net.au/147/c_historicalfeature_sins.html. Turnbull, S. 2006, ‘Halving the cost of housing: From public expenditure on infrastructure’, Economics, Henry Thornton, August 25, http://www.henrythornton.com/article.asp?article_id=4254. Wearing, A.J. 1973, ‘Growth as an Imperative’ presented in a Plenary Session Symposium on ‘Economic Growth: Magnificent Obsession’ August 17th at the 44th Australian and New Zealand Association for the Advancement of Science Congress in Perth, Australia. Williamson, O.E. 1985, The economic institutions of capitalism, Macmillan, New York. oooOOOooo 12,574/20112006

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