CONTENT’S

Acknowledgement 1
Introduction to the project 2
Capital Structure and its two theories 3
Trade-Off Theory 3
Pecking Order Theory 5
Disinvestment 7
Evolution of Disinvestment in India 9
Employment in PSUs 12
Ferrara on Money and Credit 15
Menger on Money and Credit 16
Maffeo Pantaleoni on Money and Credit 17
Bibliography 19

1
ACKNOWLEDGEMENT

2
 Introduction to Financial Management

The term Financial Management has been defined differently by different authors.
According to Solomon, “ Financial management is concerned with the efficient
use of an important economic resource, namely capital funds.”

Phillippatus has given more elaborate definition of the term financial

management. According to him “ Financial Management is concerned with the
managerial decisions that result in the acquisition and financing of short term
and long term credits for the firm”

The most acceptable definition can be, “Financial management deals with the
procurement of funds and their effective utilization in the business.”

This project basically covers the changes and different theories on Capital
Structure, Disinvestment and on Money and Credit.

3
 Capital Structure and Its Two Theories

In finance, capital structure refers to the way a corporation finances its assets through
some combination of equity, debt, or hybrid securities. A firm’s capital structure is then
the composition or ‘structure’ of its liabilities. For example, a firm that sells $20 billion
in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-
financed. The firm’s ratio of debt to total financing, 80% in this example, is referred to as
the firm’s leverage. In reality, capital structure may be highly complex and include
dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm
which come from outside of the business finance, e.g. by taking a short term loan etc.
There are two major theories for Capital Structure:

Trade-Off Theory of Capital Structure

1. Pecking Order Theory of Capital Structure

Trade-Off Theory of Capital Structure

As the Debt equity ratio (ie leverage) increases, there is a trade-off between the interest
tax shield and bankruptcy, causing an optimum capital structure, D/E*
The Trade-Off Theory of Capital
Structure refers to the idea that a
company chooses how much debt
finance and how much equity
finance to use by balancing the
costs and benefits. The classical
version of the hypothesis goes
back to Kraus and Litzenberger
who considered a balance between
the dead-weight costs of
bankruptcy and the tax saving
benefits of debt. Often agency
costs are also included in the
balance. This theory is often set up
as a competitor theory to the
Pecking Order Theory of Capital
Structure. A review of the literature is provided by Frank and Goyal. An important
purpose of the theory is to explain the fact that corporations usually are financed partly
with debt and partly with equity. It states that there is an advantage to financing with
debt, the tax benefits of debt and there is a cost of financing with debt, the costs of
financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff
leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder
infighting, etc). The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is optimizing its overall

4
value will focus on this trade-off when choosing how much debt and equity to use for
financing.

5
6
 Pecking Order Theory of Capital Structure

The Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers
and Nicolas Majluf in 1984 . It states that companies prioritize their sources of financing
(from internal financing to equity) according to the Principle of least effort, or of least
resistance, preferring to raise equity as a financing means of last resort. Hence, internal
funds are used first, and when that is depleted, debt is issued, and when it is not sensible
to issue any more debt, equity is issued.

Tests of the Pecking Order Theory have not been able to show that it is of first-order
importance in determining a firm’s capital structure. However, several authors have
found that there are instances where it is a good approximation of reality. On the one
hand, Fama and French, and also Myers and Shyam-Sunder find that some features of the
data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and
Frank show, among other things, that Pecking Order theory fails where it should hold,
namely for small firms where information asymmetry is presumably an important
problem. [

Profitability and debt ratios

The Pecking Order Theory explains the inverse relationship between profitability and
debt ratios:

1. Firms prefer internal financing.

2. They adapt their target dividend payout ratios to their investment
opportunities, while trying to avoid sudden changes in dividends.
3. Sticky dividend policies, plus unpredictable fluctuations in profits and
investment opportunities, mean that internally generated cash flow is
sometimes more than capital expenditures and at other times less. If it is more,
the firm pays off the debt or invests in marketable securities. If it is less, the
firm first draws down its cash balance or sells its marketable securities, rather
than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is,
they start with debt, then possibly hybrid securities such as convertible bonds,
then perhaps equity as a last resort. In addition, issue costs are least for
internal funds, low for debt and highest for equity. There is also the negative
signaling to the stock market associated with issuing equity, positive signaling
associated with debt.

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 Disinvestment

Disinvestment, sometimes referred to as divestment, refers to the use of a concerted

economic boycott, with specific emphasis on liquidating stock, to pressure a government,
industry, or company towards a change in policy, or in the case of governments, even
regime change.

1. A company or government organization will divest an asset or subsidiary as a strategic

move for the company, planning to put the proceeds from the divestiture to better use
that garners a higher return on investment.

2. A company will likely not replace capital goods or continue to invest in certain assets
unless it feels it is receiving a return that justifies the investment. If there is a better place
to invest, they may deplete certain capital goods and invest in other more profitable
assets.

Alternatively a company may have to divest unwillingly if it needs cash to sustain

operations.

Disinvestment in The India: Since independence, India followed the mixed economy
framework by combining the advantages of the market economic system with those of
the planned economic system. In 1991, India met with an economic crisis relating to its
external debt the government was not able to make repayments on its borrowings from
abroad. The origin of the financial crisis can be traced from the inefficient management
of the Indian economy in the 1980s. For implementing various policies and its general
administration, the government generates funds from various sources such as taxation,
running of public sector enterprises etc.

When expenditure is more than income, the government borrows to finance the deficit
from banks and also from people within the country and from international financial
institutions. When goods were imported like petroleum, payment was made in dollars
which were earned from exports. Development policies required that even though the
revenues were very low, the government had to overshoot its revenue to meet problems
like unemployment, poverty and population explosion. The continued spending on
development programme of the government did not generate additional revenue.
Moreover, the government was not able to generate sufficiently from internal sources
such as taxation.

When the government was spending a large share of its income on areas which do not
provide immediate returns such as the social sector and defense, there was a need to
utilize the rest of its revenue in a highly efficient manner. The income from public sector
undertakings was also not very high to meet the growing expenditure. At times, our
foreign exchange, borrowed from other countries and international financial institutions,
was spent on meeting consumption needs. Neither was an attempt made to reduce such

10
profligate spending nor sufficient attention was given to boost exports to pay for the
growing imports

In the late 1980s, government expenditure began to exceed its revenue by such large
margins that it became unsustainable. Prices of many essential goods rose sharply.
Imports grew at a very high rate without matching growth of exports. Foreign exchange
reserves declined to a level that was not adequate to finance imports for more than two
weeks. There was also not sufficient foreign exchange to pay the interest that needs to be
paid to international lenders. So India approached the International Bank for
Reconstruction and Development (IBRD), popularly known as World Bank and the
International Monetary Fund (IMF), and received $7 billion as loan to manage the crisis.
For availing the loan, these international agencies expected India to liberalize and open
up the economy by removing restrictions on the private sector, reduce the role of the
government in many areas and remove trade restrictions. India agreed to the
conditionality of World Bank and IMF and announced the New Economic Policy (NEP).

The NEP consisted of wide ranging economic reforms. The thrust of the policies was
towards creating a more competitive environment in the economy and removing the
barriers to entry and growth of firms. This set of policies can broadly be classified into
two groups:

The major thrust for Disinvestment Policy in India came through the Industrial Policy
Statement 1991.The policy stated that the government would disinvest part of their
equities in selected PSEs. However it did not stake any cap or limit on the extent of
disinvestment. It also did not restrict disinvestment to any class of investors. The main
objective was to improve overall performance of the PSEs.
Public sector enterprises (PSEs) or Public Sector Units (PSUs), which were given a
special role in India’s planned economy, grew both in terms of numbers and investment
for over four decades from the early 1950s. At the commencement of the First Five Year
Plan there were five PSEs with a total investment of Rs. 29 crores. At the end of the
Seventh Plan in 1990, there were 244 PSEs and the investment in them had gone up to
Rs. 99, 329 crores. Although disinvestments had started from the early 1990s, at the end
of the Eighth Plan in 1997, investment had soared to Rs. 2, 13,610 crores. At the end of
the fiscal year 2000-01, PSEs had a total investment of Rs. 2, 74, 114 crores. The PSEs
made a significant contribution to industrial production, 100 per cent in lignite, over 80
per cent in coal, crude oil and zinc, almost 50 per cent in aluminum and over 30 per cent
in finished steel.
In terms of profitability, the PSEs showed diverse patterns. In 2000-01, 122 enterprises
made a profit with the top 10 among them - giants such as the Oil and Natural Gas
Corporation (ONGC), the National Thermal Power Corporation (NTPC), the Indian Oil
Corporation (IOC) and the Videsh Sanchar Nigam Limited (VSNL) - accounting for
close to 70 per cent of the total net profit of Rs. 19, 604 crores. Sector-wise, petroleum,
power and communications contributed to 60 per cent of the profits. During that year,
there were 111 loss-making enterprises with a total loss of Rs. 12, 839 crores. The major

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contributors to the losses were Hindustan Fertilizer, the Fertilizer Corporation of India
(FCI), Bharat Coking Coal, and some other enterprises dealing with coal.

EVOLUTION OF DISINVESTMENT POLICY IN INDIA:

The policy of disinvestment has largely evolved through the policy statements of Finance
Ministers in their Budget Speeches. The policy as evolved is enumerated below:-
• In the Interim budget 1991-92, it was announced that Government would divest
upto 20% of its equity in selected PSU’s in favour of mutual funds, financial and
institutional investors in public sector.
• In the budget speech of 1992-93, the cap of 20% was reinstated and the list of
eligible investor was enlarged to include FII’s, employees and OCB’s.
• In April, 1993, Rangrajan committee recommended to divest upto 49% of PSE’s
equity for industries explicitly reserved for the public sector and over 74% in
other industries. But Government did not take any decision on recommendations.
• In 1996, as per the Common Minimum Programme, the Budget Speech 1996-97
announced the setting up of Disinvestment Commission for 3 years. CMP also
emphasized to add more transparency to disinvestment process and examine the
non core areas of public sector.
• In the Budget Speech of 1998-99, it was announced that Government
shareholding in CPSEs should be brought down to 26% on case to case basis,
excluding strategic CPSEs where Government would retain majority
shareholding. The interest of workers is to be protected in all cases. For this
purpose on 16th March, 1999, the Government classified the PSE’s into strategic
and non strategic areas. It was decided that Strategic PSE’s would be those in
areas of:
a) Arms and ammunition and the allied items of defence equipment, Defence aircrafts
and warships;
b) Atomic energy (except in the areas related to the generation of nuclear power and
applications of radiation and radio-isotopes to agriculture, medicine and non-strategic
industries); Railway transport.
c) All other PSE’s were to be considered non strategic.
• In 1999-2000 Budget Speech it was announced that Government will continue to
strengthen the strategic units and “privatizing” the non-strategic ones through
gradual disinvestment or strategic sale and devise viable rehabilitation strategies
for weak units.
• The 2000-01 Budget Speech focused on restructure and revival of viable CPSEs;
close down PSEs which cannot be revived; bring down Government
shareholdings in non-strategic CPSEs to 26% or lower, if necessary; and
protection of the interest of workers. The receipts from disinvestment will be
used for social sectors, restructuring of CPSEs and for retirement of public debt.
• The suo-motu statement 2002, specific aim was given to the disinvestment policy:
modernization and up gradation of PSEs, creation of new assets, generation of
employment and retiring of public debt.

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 • In the Budget Speech for 2003-04, Government announced details regarding the
setting up of Disinvestment Fund and Asset Management Company to hold,
manage and dispose the residual holdings of Government.

In May, 2004, Government adopted National Common Minimum Programme, which

outlines the policy of Government with respect to Public sector.
“The UPA Government pledged to devolve full managerial control and commercial
autonomy to successful, profit-making companies operating in competitive environment;
they won’t be privatized ‘Navratna’ companies can raise resources from the capital
market. Efforts will be made to modernize and restructure sick Public sector companies.
a) It favoured sale of small proportions of Government equity through IPO/FPO without
changing the character of PSE’s. In regard to this, it approved listing of unlisted
profitable CPSE’s subject to residual equity of the Government remaining atleast
51% and Government retaining the control of management.
b) It also constituted the formation of ‘National Investment Fund’. The proceeds from
disinvestment of CPSE’s will be channelized into NIF. 75% of annual income of NIF
will be used to finance selected social sector schemes- education, health, employment
and the rest 25% to meet the capital investment requirements of profitable and
revivable CPSE’s.
On 27th January, 2005 the Government, approved in principle:
• listing of currently unlisted profitable CPSEs each with a Net Worth in excess of
Rs.200 crore, through an Initial Public Offering (IPO), either in conjunction with a
fresh equity issue by the CPSE concerned or independently by the Government, on a
case by case basis, subject to the residual equity of the Government remaining at least
51 per cent and the Government retaining management control of the CPSE;
• the sale of minority shareholding of the Government in listed, profitable CPSEs either
in conjunction with a Public Issue of fresh equity by the CPSE concerned or
independently by the Government subject to the residual equity of the Government
remaining at least 51 per cent and the Government retaining management control of
the CPSE; and
• Constitution of a “National Investment Fund”.
On 25th November, 2005, Government decided, in principle, to list large, profitable
CPSEs on domestic stock exchanges and to selectively sell small portions of equity in
listed, profitable CPSEs (other than the navratnas).

It has been decided that Government would disinvest up to 20 per cent of its equity in
selected public sector undertakings, in favour of mutual funds and financial or investment
institutions in the public sector. The disinvestment, which would broad base the equity,
improve management and enhance the availability of resources for these enterprises, is
also expected to yield Rs. 2,500 crores to the exchequer in1991-92.

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Problems Associated with Disinvestment: A number of problems and issues have
bedeviled the disinvestment process. The number of bidders for equity has been small not
only in the case of financially weak PSUs, but also in that of better-performing PSUs.
Besides, the government has often compelled financial institutions, UTI and other mutual
funds to purchase the equity which was being unloaded through disinvestment. These
organizations have not been very enthusiastic in listing and trading of shares purchased
by them as it would reduce their control over PSUs. Instances of insider trading of shares
by them have also come to light. All this has led to low valuation or under pricing of
equity.

Further, in many cases, disinvestment has not really changed the ownership of PSUs, as
the government has retained a majority stake in them. There has been some apprehension
that disinvestment of PSUs might result in the ‘crowding out’ of private corporates
(through lowered subscription to their shares) from the primary capital market

An important fact that needs to be remembered in the context of divestment is that the
equity in PSUs essentially belongs to the people. Thus, several independent
commentators have maintained that in the absence of wider national consensus, a mere
government decision to disinvest is not enough to carry out the sale of people’s assets.
Inadequate information about PSUs has impeded free, competitive and efficient bidding
of shares, and a free trading of those shares. Also, since the PSUs do not benefit
monetarily from disinvestment, they have been reluctant to prepare and distribute
prospectuses. This has in turn prevented the disinvestment process from being completely
open and transparent.

Lastly, to the extent that the sale of government equity in PSUs is to the Indian private
sector, there is no decline in national wealth. But the sale of such equity to foreign
companies has far more serious implications relating to national wealth, control and
power, particularly if the equity is sold below the ‘correct’ price.

If the disinvestment policy is to be in wider public interests, it is necessary to examine

systematically, issues such as – the ‘correct’ valuation of shares, the ‘crowding out’
possibility, the appropriate use of disinvestment proceeds and the institutional and other
prerequisites.

Disinvestment is generally expected to achieve a greater inflow of private capital and the
use of private management practices in PSUs, as well as enable more effective
monitoring of management discipline by the private shareholders. Such changes would

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lead to an increase in the operational efficiency and the market value of the PSUs. This in
turn would enable the much needed revenue generation by the government and help
reduce deficit financing.

15
 Employment in PSEs:
As Figure 1 shows, employment in the central PSEs has declined from about 2.2 million
in 1991- 92 to about 1.7 million a decade later. A marginal rise in 2001-02 is on account
of the shift of employment from department of telecommunication to incorporation of
BSNL as a corporate entity. If one traces employment in a set of same enterprises over
the 1990s, perhaps the decline would be greater. The fall in employment is clearly the
result of voluntary retirement scheme (VRS) initiated using the National Renewal Fund,
as part of the structural adjustment programme.
Popular reports suggest some retrenchments and compulsory retirement of workers.
Reportedly some private firms have violated their contract in this regard (Modern Foods,
for instance). There are also reports of employment generation at BALCO on account of
capacity expansion

Before seeking evidence on the effects of the D-P in India, perhaps it would be useful to
ask how valid were the premises of the disinvestment policy to begin with. It is widely
believed, as large and growing share of the fiscal deficit was on account of PSEs’
financial losses getting rid of them would restore the fisc back to health. How valid was
such a diagnosis? Nagaraj (1993) had shown, using a widely accepted a methodology that
PSEs’ financial losses were not the principal cause of the growing fiscal deficit in the
1980s, and in fact PSEs’ share in the fiscal deficit had steadily declined in the decade. In
other words, the government per se was largely responsible for the growing fiscal deficit,
not the enterprises owned by it.

Updating these estimates for the 1990s using a more refined method, the estimated
deficits of the general government confirmed our previous findings (Figure 2).
Government’s share (in terms of equity and debt) as a proportion of PSEs’ total fixed
investment shows a steady decline since the mid-1970s, suggesting a gradual tightening
of their budget constraint (Figure 3). The decline in government’s contribution is being
met increasingly by a rise in internal resources (Figure 4).
These long-term trends indicate, contrary to the widely held views, the growing fiscal
deficit since the 1980s is not on account of financial losses of the enterprises.

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It is widely believed that PSEs’ respectable profitability ratio (gross profits to capital
employed) is mainly on account of the surpluses of the petroleum sector enterprises
whose pricing includes an element of taxation. Interestingly, as shown in Figure 5, the
profitability ratio has improved since the 1980s even excluding the petroleum sector
enterprises – a clear evidence on improvements in PSEs financial performance. But could
it be merely due a faster rise in administered prices of PSEs’ output (on account of their
monopolist position in the domestic market)? This is not so, as evident from the fact that
the ratio of deflators of public sector output and GDP has declined since the mid-1980s
(Figure 6).

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 Ferrara on Money and Credit

The main reference for Ferrara’s theory of money and credit is the 1856 introduction to
the volumes V-VI of the Biblioteca dell’ Economista, entitled ‘Della moneta e dei suoi
surrogati’ (or, the English, “On money and its substitutes’ 1856 [1961]).
According to Ferrara, the essence of money was to be found in its double role as a
universal equivalent and a real pledge. Concerning the first, Ferrara’s views were quite
conventional: money is accepted as a means of exchange, that is, it is demanded not to be
consumed but to be exchanged with other goods thanks to ‘its ability to be transformed
into whatever we need’. As to the second role, he claimed that money acts as a real
pledge during the interval separating the two phases of exchange, the sale of some goods
and the purchase of other goods. Thus, Ferrara endorsed theoretical metallism: there can
be no fiat or paper money because no agent would ever accept in exchange of his goods
something devoid of intrinsic value, that is, of the only guarantee (namely, the pledge)
that in case she cannot employ her money to purchase other goods she will nonetheless
be able to draw some utility from it.

The realist approach to the nature of money is confirmed by Ferrara’s explanation of the
logical origin of its functions as an equivalent and a pledge. From an individual’s
viewpoint, a thing is accepted as money because everybody accepts it in exchange for
goods. The general acceptability or transferability of money is ‘a highly important [fact],
which could be called constitutive of money’. If paper, or even mud, were universally
accepted as much as gold and silver are, paper and mud could well act as a means of
exchange and become money. That this does not happen proves that universal
acceptability does not suffice to account for the logical nature of money. The
transferability property must be based on an objective feature recognizable by everybody:
this requirement of objectivity explains why gold and silver are used as money while
paper and mud are not. Such an objective feature is, of course, the precious metals’ own
utility. Hence, Ferrara concluded that the tacit confidence in the universal acceptability
and general transferability of gold and silver depends on the intrinsic qualities of the two
metals, that is, on their ability to act as a real pledge.

Ferrara focused on the two polar cases of a credit backed by a fund whose physical
existence and economic value are well determined—say, a plot of land-and of a credit
backed by a still non-existent value—say, that of a future harvest . In the first case, the
landlord may easily spend the value of his land in exchange. While the landlord may
sometimes find it either impossible (for lack of a buyer) or non-profitable (because of a
low market price) to spend such a value, he can always borrow its money equivalent, so
much so that the borrowed amount fully replaces the land’s value. In the second case, the
farmer only owns a ‘mental value’, that is, an expectation, which can hardly be spent in
exchange. Thus, until the harvest takes place, such a value is “embodied in the [farmer’s]
trust, in his work, in his personal abilities, or, better, in his mind’. What credit actually
does is to transform into money ‘a value that is hampered by a matter of time’: the lender
allows the farmer to wait until the harvest, that is, ‘takes the burden of time off the

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farmer’s present value and places it upon himself’. This, according to Ferrara, was the
logical essence of credit. Indeed:

Menger on Money and Credit

Carl Menger (February 28, 1840 – February 26, 1921)

was the founder of the Austrian School of economics,
famous for contributing to the development of the
theory of marginal utility, which contested the cost-of-
production theories of value, developed by the classical
economists such as Adam Smith and David Ricardo.

Menger’s two main works on the nature and origin of

money are two chapters (Chapters VII-VIII) of the 1871
Grundsatze and the classic 1892 paper in the Economic
Journal. .

Menger’s problem was to explain, in terms of the

rational choice of selfish agents, the ‘mystery’ of
money, that is, the circumstance that some goods have
become universally accepted as means of exchange.
Indeed, the agents’ behavior in a monetary economy
looks irrational, as they exchange their useful goods
with another one, money, which gives them no direct
utility. What Menger did was to demonstrate that this behavior may well be explained in
terms of individual rationality. His argument centered on the notion of marketability, or
saleableness: goods have a variable degree of marketability (Menger 1871 [1994], pp.
258-60); money has the highest degree of marketability; hence a theory of marketability
is the logical prerequisite for any theory of money. .

A good’s marketability is defined as the ease of selling it, at any time and any place, at an
economic price—the latter being a price corresponding to the “present general economic
conditions. Menger claimed that past economists had failed to recognize that the buyer of
a certain good who has paid a given price for it can never re-sell the good immediately
and at the same price. Bid and sale prices are always different even in the best organized
market; hence, while one can always buy a good, at any time and at a definite price, one
can never sell the same good at any time. at least not without suffering a loss of variable
size. The different goods may therefore be classified in terms of their marketability by
looking at the ease with which they can be sold. at any time, at a price at least
approximately equal to their purchasing price.

Menger’s implicit conclusion was that money is a mechanism which endogenously

allocates market power, thereby constantly modifying the economy’s exchange structure.
As I show below, this will also be Pantaleoni’s conclusion, though the Italian economist
will extend it to the banking system as well.

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21
 Maffeo Pantaleoni on Money and Credit

Maffeo Pantaleoni (Frascati 1857- Milan 1924)

was an Italian economist, and a notable
proponent of neoclassical economics. He was
occasionally referred to as "the Marshall of
Italy", because of his unrelenting defense
of laissez-faire economic policies.

Later in his life, before and during World War I,

he became an ardent nationalist and anti-
socialist politician, with close ties to
the Fascist movement. He was Minister of
Finance in the Carnaro government of Gabriele
D'Annunzio at Fiume, which lasted for fifteen
months between 1919 and 1920. Shortly before
his death, he was elected to the Italian Senate.

Pantaleoni was a major contributor to the Italian

school of economics known as 'La Scienza delle
Finanze'. His book 'Teoria della Traslazione dei
Tributi' (theory of tax shifting) is a pioneering
study of tax incidence. According to Nobel prize winner James M. Buchanan, Pantaleoni
and his followers (such as Antonio De Viti De Marco and Vilfredo Pareto) can be
considered the intellectual forefathers of the modern public choice theory.

Maffeo Pantaleoni’s (1857-1924) analysis of money and banking and aims at

demonstrating that the Italian economist developed one and the same theory for both
institutions. The central feature of this theory was the notion of flexibility and its main
claim was that the most important function of money and banks is the loosening of the
real and temporal constraints imposed on production and exchange activities by the
complementarily relationships among production factors. My general point is that such a
theory provides the key to interpret the whole of Pantaleoni’s economics because it
establishes a strong connection between the two cornerstones of his thought, namely,
what he called “the law of defined proportions’ and the dynamics of disequilibrium and
structural instability. This connection is, in turn, crucial if one wishes to understand how
he turned from the ‘pure’ equilibrium theory of the 1889 Principii—where perfectly
rational, forward-looking agents lead the system to an efficient equilibrium—to the
‘impure’ theory of his later essays, in which the economy is populated by agents with
limited foresight and bounded rationality, where no general or partial equilibrium may
arise, let alone an efficient one.

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Influenced as they might have been by Ferrara and Menger, Pantaleoni’s own views on
money and credit also descended from his classification of goods and analysis of capital
in the Principii di Economia Pura, which was published 1889.

The direct utility goods are those directly satisfying an agent’s needs; hence, they are the
only goods which are really desired by individuals. The complementary goods are those
which may satisfy a need only if used together with one or more other commodities. The
instrumental goods are those giving no direct satisfaction as they are only instrumental in
obtaining either the direct utility or the complementary goods; among them feature the
primary goods and the productive services, including labour. Any commodity may
belong to any of the three categories, depending on the needs it is to satisfy. In particular,
and remarkably for his theory of money, Pantaleoni claims that any direct utility good
may become an instrumental one if it is used for exchange

Pantaleoni observes that the complementary goods give no utility to the agent unless they
are used according to the law of definite proportions (LDP). The law claims that,
generally speaking, every economic process, be it production or consumption, takes place
according to well-defined proportions among the goods and services involved in it. Such
a general law, which is a manifest violation of the neoclassical principle of general
substitutability in production and consumption, is absolutely crucial in Pantaleoni’s
economics. Indeed, the law entails that, first, every quality of the ‘things’ forming the
subject of economic analysis exists in a well-defined measure, and, second, any
proportion between ‘things’ is actually a relationship between qualities, that is, between
measures

The availability of capital is a necessary condition for individuals to deviate resources

away from the production of direct utility goods and towards the production of those
instrumental commodities, which will later allow an easier, or cheaper, production of
direct utility goods. The amount of capital required for this task depends on both the
length of the instrumental goods’ production process and the workers” consumption
level: this is synthesized by the claim that capital enables workers ‘to tide over the
interval between the beginning and end of the production of an instrumental commodity’

Pantaleoni underlines that confidence does not necessarily depend on the intrinsic,
objective features of the ‘thing’ acting as the means of exchange. On the contrary, the
real motives underlying this confidence, that is, the reasons for money’s ‘exchange
potential’, are totally ‘immaterial: one thing will serve the purpose of money equally as
well as any other, provided that an equal degree of confidence be placed in it’ .

This explains why he avoids investigating how confidence may arise (or be lost) in the
first place: he takes it for granted, as if equilibrium of interactive expectations had
already been achieved, and constantly preserved, in the economic system.

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 BIBLIOGRAPHY

1. North American Journal of Finance and Banking Research Vol. 3. No. 3. 2009,
By Carmen Cotei & Joseph Farhat: THE TRADE-OFF THEORY AND THE
PECKING ORDER THEORY: ARE THEY MUTUALLY EXCLUSIVE?
2. A study on Disinvestment and Privatization in India Assessment and Options
By R Nagaraj
3. From Marketability to Flexibility: Pantaleoni's 'Impure' Theory of Money and
Banking By Nicola Giocoli ,University of Pisa -Department of Economics
4. Army Financial Management Force Structure By Paul Cartmell,
5. FINANCIAL MANAGEMENT POLICY MANUAL NAVSO P-1000 Rev
through Change 67 12 December 2002 By DEPARTMENT OF THE NAVY
OFFICE OF THE ASSISTANT SECRETARY OF THE NAVY (FINANCIAL
MANAGEMENT

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