Sequestered Capital

Sequestered capital is capital that is hidden or unseen by the market. R&D is often sequestered capitaI. New goods in production can be sequestered capital. Sequestered capital is special because it doesn’t inform price signals. In a series of papers, McClure and Thomas use the idea of sequestered capital to explain market anomalies. In this paper they look at sequestered capital and the Dutch tulipmania.

Framing tulipmania in terms of sequestered capital – capital whose quantities, usages and future yields are hidden from market participants – offers a richer and more straightforward explanation for this famous financial bubble than extant alternatives. Simply put, the underground planting of the tulip bulbs in 1636 blindfolded seventeenth-century Dutch speculators regarding the planted quantities and their development and future yields. The price boom began in mid November 1636, coinciding with the time of planting. The price collapse occurred in the first week of February 1637, coinciding with the time of bulb sprouting – signaling bulb quantities, development and future yields. Also consistent with our explanation is the initial price collapse location, in the Dutch city of Haarlem, where temperature and geography favored early sprouting and sprout visibility.

In a working paper (with Steve Horwitz) they look at sequestered capital and closed end funds. Sequestered capital is an interesting idea perhaps with many other applications.


Well, that is certainly useful in combination with the framing of this incident, since nobody knew what was happening an ocean away - 'The Mississippi Company (French: Compagnie du Mississippi; founded 1684, named the Company of the West from 1717, and the Company of the Indies from 1719[1]) was a corporation holding a business monopoly in French colonies in North America and the West Indies. When land development and speculation in the region became frenzied and detached from economic reality, the Mississippi bubble became one of the earliest examples of an economic bubble.'

Hard to tell how useful that explanation would be in terms of the housing bubble, but one could assume that rampant fraud is also an underground activity.

We hope to put out a paper on the housing bubble in the near future.

The housing bubble is interesting on two fronts. First, the mortgage-backed securities were highly sequestered in that no one could accurately determine the quality of the underlying mortgages, and second, new housing construction is largely sequestered during the 18 to 24 months of planning, permits, and construction. The result was that once the foreclosures began to increase, the derivatives collapsed in value, and when sales of new homes stalled, the builders ceased to apply for permits—too late for the 4.5 million homes already under construction.

Sequestered Capital is also behind the hoary "Cambridge Capital Controversy", where, among other things, you must factor into GDP "intangibles" in order for the capitalist system to work. Put another way: why is Facebook worth more than GM, or Apple worth $1T? It cannot be from their physical capital. It's intangibles. Sort of like Marx's fallacies in Das Capital, where the sums don't work, but different.

Also the John Law French Mississippi scheme and the corresponding South Sea bubble across the Channel was an attempt at broadening the tax base from inefficient French tax farmers to something more 'democratic'. It failed to to rampant speculation but today's fiat government deficit financing, based on a 'promise to pay someday in the future' is essentially John Law's scheme.

Bonus trivia: I had no idea WWI military dirigibles went to 7200 meters, that's nearly 24000 feet, where today's jumbo jets fly! Amazing (though their usual altitude was well below that, around 4000 meters = 13000 ft). And they had a potential range of 7000 miles (11.3 km), which again rivals today's jumbo jets. Smooth flight too, counter-intuitive, and speeds of about 100 kph (62 mph). First class flying. Not sure if it's fuel efficient though, probably not.

Sorry, Ray, but the question of intangibles has nothing to do with the Cambridge controversies in the theory of capital.

Also, while both the Mississippi and South Sea bubbles were directed at increasing revenues for the government (at least in the short run), characterizing either as a scheme to "widen the tax base" is simply inaccurate.

So, they found that things we thought were unexplainable are in fact explainable by something unseen and unmeasured that we presume existed at the time?

Scientists had phlogiston and ether. Why should economists miss out on the fun of playing scientist?

Besides, when you have a metaphor involving invisible as one of the high points of your discipline, why not run with invisibility as far as possible?

No need to go that far back. Dark matter, dark energy, and inflation are all fundamental parts of current explanations for observed cosmology, yet they remain impervious to direct observation.

Heck a lot of physicists like to invoke untold numbers of unseen universes to explain quantum behaviors. Not only do we lack evidence, but many of these same physicists believe that we cannot find evidence of these many worlds.

We found something important that what Hayek overlooked:

It can be seen and measured after the fact. It's very unlikely that the tulip sprouts suddenly appeared one day without having been planted a few months prior

Of course, "sequestered capital" is the same as the absence of transparency, which is the characteristic of tech. As I indicated in my comment to Cowen's post this morning, tech doesn't own or produce much in the way of tangible assets and, instead, owns and produces intangible assets, which can't be seen or touched. What is the value of something that is hidden from plain sight. If investors could see the tulips, I mean the intangible assets, would the value placed on the tulips, I mean tech, plummet?

Sequestered capital theory is more nuanced than "tech" because it explicitly distinguishes process R&D from new-product R&D. The former is promptly constrained by the price and production signals of lateral competitors (whose products are already on the market); in the case of new-product R&D, products are not yet (by definition) , on the market and consequently laterally competing firms CANNOT observe each others preparations.

So how does SQT apply to self driving cars or other large scale (partially visible) R&D efforts? How much of the capital is sequestered? Just the ML algorithms?

*SCT not SQT

For starters, SCT would advise against subsidizing R&D.

Related working paper available on SSRN:

How does one observe a product that is intangible?

it Is not the tangibility of a good that matters, but the unobservable nature of the sequestered capital investment in them. Swarming into a new industry can lead to significant overinvestment—particularly if the government provides tax credits for the investment.

It seems like quantifying the idea that insiders know more

Even if no one knows it in advance, it still is a thing.

For bubbles, I would hypothesize that the people who stay out of the bubbles do so because they have general doubts, as opposed to having secret information that beliefs that drive the price increase are wrong.

Finance types can cause boundless amusement with their models. A ,ajar use of derivatives is to hide what is going on, from shareholders, from regulators, from other managers, and from bosses. Generally, most people in business want to hide some portion of profits. Not necessarily to steal it, but to have an emergency supply of cash for when things go tuts ip. This is human nature. This is why there have been for a very long time laws against secret profits. Calling the problem “sequestered capital” is pompous nonsense. Microsoft used to buy mountains, rare art and all sorts of assets, not particularly to hide the assets from investors, but to ensure that in tough times they’d have something to sell. Making the company look less fantastically profitable might have also been a welcome side benefit.

I agree that fraud is a kind of sequestering, and should be dealt with under common law. More interesting is when the aggregate efforts of entrepreneurs add up to over production and a poor allocation of resources (e.g. the dot com boom), or a shock to demand for an inelastic good (such as housing after GW Bush and congress pushed for a relaxing of qualifications) leads to over production. The lack of financial transparency into derivatives has occurred over and over and is not always the result of fraud.

Sequestered capital brings up the interesting observation that just because capital is hidden from the view of the market and not priced, does not mean it is not subject to market forces. In this vignette sequestered capital becomes a significant market player as the surplus bulbs cause the price collapse.
Or to turn it around: just because we see economic value being created with resources but cannot see where and how it is priced, does not mean the activities are not subject to the market forces. Perhaps there is no market failure after all.

Presumably not all "bubbles" are explicable in terms of sequestered capital, but probably quite a large proportion are, because "bubbles" are best described as a rapid shift in expectations.

The US subprime collapse is a great example -- since expanding credit at the cost of information was more or less what the working papers on securitization, community-building, federal guarantees, etc. promised all along, the tulip traders of 2007 were trying to price default risk through several inches of bipartisan-approved dirt.

This is still a good read even if you're familiar with the various levels of soil the government strongly encouraged lenders to place between secondary loan markets and borrowers.

I have not yet read the linked to paper, but hope to soon. Offhand it seems reasonable that the desequestering of sequestered capital could have an impact on the relevant markets, including possible triggering the end of a bubble. However, if the paper claims that all bubbles are due to "sequestered capital," well, I think that would depend on having a definition of "sequestered capital" to be so broad as to be essentially vacuous.

As it is, let me introduce another term, the favored term of classical political economists who discussed speculative bubbles from Cantillon through Adam Smith to Marx: fictitious capital. I think that is a great label for bubbly value of an asset above its fundamental (if that can be identified, not always the case), whether that overvaluation is due to some sequestering of capital or not.

Hello! All forms of communication exchange (economic transactions being a subset of communications) involves risk. Networks reduce risks; not the actions of individuals. (Note, networks are nothing without individuals and vice versa). Bubbles result when efficient network processes are impeded and risk becomes imbalanced. There is no such thing as sequestered capital; just levels of risk.

Firms doing new-product research and development require employees to sign non-disclosure agreements under trade secret law for the express purpose of keeping their uses of capital hidden from laterally competing firms. This is a straightforward and clear example of sequestered capital.

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