What has prompted us to write this article was a question by a reader, who asked us to flesh out the production structure concept by means of examples. Since this is a mere blog post, what follows below is by necessity only a very rough outline of the ideas and concepts involved, which we however hope will nonetheless be helpful to readers that are not familiar with them. Those interested in a detailed and comprehensive analysis should consider reading ‘Human Action’ by Ludwig von Mises and ‘Man, Economy and State’ by Murray Rothbard, which are the main sources referenced in this post. Other books of interest in this context are Friedrich von Hayek’s ‘Prices and Production’ and ‘A Pure Theory of Capital’, as well as J.H. de Soto’s ‘Money, Bank Credit and Economic Cycles’. An extensive treatment of the role of the pool of real funding in production can be found in Richard von Strigl’s ‘Capital and Production’.
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One of the major differences between the Austrian school and other economic schools is in capital theory. In particular, Austrians hold that the economy has a complex production structure consisting of many stages. This capital structure needs to be funded by real savings and is coordinated by interest rates.
In order to elucidate some of the basic tenets of this theory, Austrian economists from Eugen von Böhm-Bawerk to Murray Rothbard have employed the example of Robinson Crusoe, an example of an ‘autistic economy’. Naturally after considering Crusoe, one must move on to a larger society in which there is cooperation, indirect exchange and a division of labor. Alas, Crusoe serves very well to ‘begin at the beginning’.
As Ludwig von Mises notes in Human Action, ch. XIV:
“No other imaginary construction has caused more offense than that of an isolated economic actor entirely dependent on himself. However, economics cannot do without it. In order to study interpersonal exchange it must compare it with conditions under which it is absent.”
Imagine Crusoe arriving on his island after being shipwrecked. At this point, all he has at his disposal to ensure his survival are the nature given resources he finds on the island and his labor. At this point one can already make an important observation: whatever the state of Crusoe’s technological knowledge acquired during his previous life in civilization, it is only of limited value in this particular situation. Since there are no capital goods on the island, he has to start from scratch.
In Rothbard’s ‘Man, Economy and State’, Crusoe picks berries for his survival. In the course of one day, he manages to pick 200 berries in 8 hours, which is just enough for him to survive. Since Crusoe is an inventive fellow, he soon begins to think about how to improve this situation. One way of doing so would be by fashioning a stick that could be used to access the berries more easily and would improve his rate of production.
Note here that the picking of berries is the equivalent of producing a consumer good. There is one other consumer good at Crusoe’s disposal, namely his leisure time.
Crusoe now begins to plan. He concludes that making a useful stick will likely take him an entire day. However, he can not simply stop picking berries unless he wants to risk going hungry. So he decides to save some berries. He now must decide to either eat less, or sacrifice some of his leisure time or a combination thereof in order to save a sufficient stock of berries. Let’s say that he eats 15 berries less per day and works for one hour longer, which would enable him to save 40 berries per day (his unaided hourly production rate is 25 berries). After five days, he has saved 200 berries which will be enough to see him through the time required for stick production.
Here it should be noted that before embarking on this project, Crusoe has already some idea of the increase in productivity the stick will help him to achieve. Let us say he can be reasonably certain that his productivity will increase by 100%, i.e., the stick will improve his hourly rate of production to 50 berries from 25. By deciding to give up one hour of leisure and the eating of 15 berries per day for five days, Crusoe reveals that the higher productivity he expects to achieve with the help of the stick – this is to say the greater amount of consumer goods he will be able to produce and consume in the future – is worth more to him than the 15 berries plus one hour of leisure time he could consume in the present.
We can also say that Crusoe’s time preference is low enough to make him value the yield he can expect in the future higher than the amount of berries and leisure time he must give up in the present. In other words, the inducement to accumulate savings is given by his time preference: the weighing on his personal value scale of the enjoyment the greater amount of future consumption will bring against the sacrifice of having to give up a certain amount of present consumption.
In Crusoe’s case described above this seems an easy enough decision, but regardless of whether the decision is easy or more difficult, it is a decision every economic actor must constantly make anew.
Once Crusoe’s act of saving is finished, the stock of berries he has accumulated to see him through the day he will require to produce the stick represents his pool of real funding, or his subsistence fund. As noted above, this pool of savings in the form of berries is what will sustain him during the production period. Here we can immediately see the role the pool of real funding plays in production. Crusoe must make a correct estimate of the size of the subsistence fund required to sustain him while he produces the stick. If he underestimates it and sets too few berries aside, he will be forced to abandon the stick production in medias res and resume picking them by hand if he doesn’t want to starve.
The stick in turn is a capital good – a good that is a produced factor of production. Once Crusoe is finished with fashioning the stick, he can go about mixing capital (the stick), land (the berry bushes growing on the island) and his labor to produce the consumer good (berries) more efficiently.
Before embarking on stick production, Crusoe only had a single stage of production – he was producing the consumer good directly by employing only land and labor. By adding another stage – the production of a capital good by mixing land and labor in a different endeavor – he has created a primitive two-stage production structure. An important point is here that by adding a stage of production involving the production of a higher order good, the entire process has become more time consuming ab initio, but in return enables higher productivity down the road. Once Crusoe’s stick is operational, he can produce twice as many berries as before, which opens up a vista of further choices to him that did not exist before. He could for instance work only four hours instead of eight and enjoy four more hours of leisure. Or he could continue to work for eight hours and save his excess production in order to make it possible for him to embark on yet more new projects. This latter point is quite important: by increasing his productivity in the harvesting of berries, Crusoe now has the possibility to produce other goods he could not afford to produce previously (such as a hut, a spear for fishing, etc.).
Here it should be noted that the stick, useful as it is, won’t last forever. So-called ‘durable’ capital eventually wears out, which is to say, it is used up in the production process, albeit at a slow rate. So Crusoe must plan for the eventual replacement of the stick, or in other words, if he wants to have continuous use of a stick, he must save a little for the purpose of capital maintenance.
In Crusoe’s case, since his is a one-man show, all stages of his production activities are vertically integrated, but it is nonetheless conceivable that he might add yet a third stage to his berries-related production structure. For instance, the production of sticks might be accelerated by first producing a knife-like instrument from a stone, an activity known as ‘flint knapping‘.
Given that Crusoe is alone, it probably wouldn’t make much sense for him to concentrate too much on improving the productivity of stick making as such, but if he were to produce such an additional capital good, one of the considerations involved would no doubt be that a stone knife represents a fairly non-specific capital good, i.e., it could be put to various uses and may help with the production of yet other useful goods.
Let us say that years later, by which time Crusoe already resides in a nice tree hut and has created all sorts of amenities and efficient food production processes which were inconceivable when he first arrived, the berries suddenly die out due to an unexpected fungus infection. In that case, the berry-harvesting sticks – provided they are only useful for this one purpose – would become entirely useless. If Crusoe had fashioned a small stock of berry sticks in advance, he would suddenly be faced with idle capacity. If Paul Krugman ever heard of this, he would be apoplectic. :)
Our point however is this: a highly specific capital good is only of value as long as the specific task in production it is used for is still possible or sensible. The berry-harvesting sticks would become useless if berries were to disappear. By contrast, the comparatively non-specific stone knife would continue to be useful for other purposes.
Another point worth mentioning here is that capital goods are in the end always a result of mixing land with labor (‘land’ is the catch-all for all resources provided by nature, including of course land simply as ‘standing room’). As Richard von Strigl notes in ch. 1 of ‘Capital and Production’:
“Labor and land (insofar as the best qualities are not available in superabundance) have been called the originary factors of production, and these have been contrasted with capital as a produced factor of production. However, if one accepts this formulation, one may not forget that when employing capital, one is never employing a new type of factor of production, but rather is using originary factors of production in a special way—since it can only have been produced out of originary factors of production. Whenever we speak of production capital, we must refer to the use of originary factors of production, the circumstances under which originary factors of production are used, and their effects.”
In summary, from the observations concerning autistic exchange we learn:
- without capital, life would be mere subsistence on the edge of starvation. Only momentary production to ensure bare survival would be possible.
- in order to create capital, one must first save.
- in order to maintain or add to said capital, one must save even more.
- the decision of whether and how much to save or consume depends on time preference, i.e., the actor’s personal evaluation of the enjoyment of present vs. a more ample supply of future goods.
- in order to improve productivity, i.e., to produce more with fewer or the same inputs, one must add new stages of production increasingly remote from the final stage, the production of the desired consumer good(s). This means the production process will become longer and more time consuming. The more production stages are added, the more time consuming and more productive production processes become.
- there are specific (useful for only one purpose) and non-specific (useful for various different purposes) capital goods.
- capital goods, or produced factors of production, when combined with other, complementary capital goods, nature and labor will yield lower stage capital goods and eventually consumer goods.
These basic concepts are not altered in a complex economy based on indirect exchange and the division of labor. Naturally, the society-wide cooperation between various participants in the market economy allows for building an increasingly complex and far more productive production structure.
Time Preference and Interest
When Crusoe decides upon his stick production project, he will only decide to forego some of his present consumption if he values the larger amount of berries he will be able to consume in the future more highly. If the amount of berries available in a remoter time period is the same as that available today, then the immediately available berries will be considered to be of higher value. This phenomenon is referred to as time preference. The discount or spread between the value placed on future as against present goods represents the natural interest rate. Crusoe’s autistic exchange situation helps us to illuminate the important point that interest is a non-monetary phenomenon. Obviously, Crusoe has no use for a medium of exchange, since he is alone. And yet, it is clear that he will ceteris paribus always value present goods more highly than future goods. What induces him to save berries in order to be able to embark on the production of a capital good is the fact that the agio between the expected future goods vs. the present goods the enjoyment of which he must give up is big enough to make him value the future goods more highly. As Ludwig von Mises writes in Human Action, ch. XIX:
“Originary interest is the ratio of the value assigned to want satisfaction in the immediate future and the value assigned to want satisfaction in remoter periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself.”
[…] and further, ibid.:
“There are always goods the procurement of which we must forego because the way that leads to their production is too long and would prevent us from satisfying more urgent needs. The fact that we do not provide more amply for the future is the outcome of a weighing of satisfaction in nearer periods of the future against satisfaction in remoter periods of the future. The ratio which is the outcome of this valuation is originary interest.”
As we have also seen above, Crusoe adds a stage of production in order to improve the productivity of his berries harvesting. This lengthening of the production process means there will be a longer waiting time until he comes into possession of the desired consumer good. Crusoe’s time preference is the decisive factor in his deciding on how much to consume, and how much to save and invest. It follows from this that a lower time preference will lower this discount – or putting it differently, an increase in savings and a lower interest rate go hand in hand, whereas a higher time preference will express itself in the opposite manner (lower savings and a higher interest rate).
It should be noted to this that in the real world, the determination of interest rates is subject to additional factors. Apart from the originary interest rate due to time preferences, they will contain a risk premium (e.g. depending on the assessment of a borrower’s creditworthiness), a ‘price premium’ to account for expected changes in money’s purchasing power (in the fiat system this will always be an agio, since the purchasing power of money only ever declines), and an entrepreneurial profit component (lenders are businessmen, and strive to make an entrepreneurial profit as well).
Indirect Exchange and the Division of Labor
Consideration of Crusoe’s autistic existence has furnished us with a number of principles. These can be applied in the context of a complex market economy with numerous participants as well. An important new factor that enters the proceedings now is exchange. Let us say that after fully exploring his island Crusoe becomes aware of the fact that he is not alone after all. People are living in a part of the island he had previously not visited. This opens the possibility of economic cooperation in the form of exchange. Crusoe produces the consumer good berries and he has the know-how to produce the harvesting stick. He finds that Tim Smith who lives on the other side of the island is a fisher. They may now decide on an exchange of berries for fish. Smith will have to decide how many berries he wants to get per fish, while Crusoe will have to decide how many berries he is prepared to give up per fish. If an exchange takes place (at, say a rate of 25 berries per fish), then both Smith and Crusoe have profited from it, since both valued what they received in the exchange more highly than what they had to give up. If we extend this now to several people, all of whom are engaged in the production of different goods, a problem will soon appear, namely the problem of the coincidence of wants. A producer of a more durable consumer good such as e.g. Jones the shoemaker may find that he can not always get berries from Crusoe when he wants them in exchange for shoes. Crusoe’s need for shoes is likely to be on a different time scale than Jones’ berries requirements. The solution for this problem is the adoption of a medium of exchange. Which good is most useful for the purpose will be determined by a process of trial and error, but generally it will be the good of the highest marketability, i.e. a good that is likely to be accepted by the majority of market participants in exchange will eventually be preferred. Several other factors besides high marketability are important: durability, fungibility, divisibility, a high exchange value per unit weight (a side effect of scarcity). Once a good becomes widely adopted as a medium of exchange, it becomes effectively money. The emergence of money allows for increased specialization – i.e., the division of labor will be greatly extended by it.
Since money is readily exchangeable for all other goods, it is the ultimate present good. In production processes it allows for precise economic calculation, which would be very difficult if not impossible without it. Conceptually we can connect money with the economy’s subsistence fund as follows: Let us say that once Crusoe has learned of the other inhabitants, he decides it would be economically sensible for him to concentrate on the production of berry harvesting sticks instead of berries production, since he has a comparative advantage in this line. This advantage may e.g. consist of the fact that the type of wood most useful for such sticks grows only on the piece of land he has appropriated. Moreover, he may have know-how regarding the production process that others lack. In order to make the production process more productive, he decides to add a stage for which he hires a worker from the nearby village. The worker’s job is to scour Crusoe’s land for the most useful pieces of wood and collect them for him. Previously, when Crusoe produced berries himself, he may have paid his worker in berries in order to sustain him. Now, other berry producers are Crusoe’s customers. If they were to pay him in berries, he could pay his worker in berries as well. Let us assume though that a commonly accepted medium of exchange is already in use, say silver coins. Crusoe gets paid in silver coins, and he pays his worker with silver coins too. In effect, he has given his worker present goods in exchange for future goods. The worker collects the pieces if wood which will be made into sticks, which in turn will be used for berry harvesting. A three stage production structure has emerged, and the payment of silver coins allows both Crusoe and his worker to sustain themselves during the production process by exchanging the silver coins for whichever consumer goods the require for the purpose.
The Evenly Rotating Economy
The evenly rotating economy (ERE) is a conceptual tool that is helpful in explaining how the production structure operates. The ERE is the state of ‘equilibrium’ which the economy constantly strives to reach, but which is unreachable in the real world of uncertainty and constantly changing market conditions and data. There is no uncertainty in the ERE, and therefore there is no entrepreneurial profit or loss. In fact, there are no entrepreneurs in the ERE. All economic activities in the ERE are constantly repeated, value scales and the stock of resources always remain the same. It is an abstraction in which certain elements of the real economy are assumed not to exist.
Mises notes in Human Action, ch. XIV:
“In reality there is never such a thing as an evenly rotating economic system. However, in order to analyze the problems of change in the data and of unevenly and irregularly varying movement, we must confront them with a fictitious state in which both are hypothetically eliminated.”
The reason why it makes sense to analyze production with the help of this artificial construct is that it serves to reduce the complexity of the subject. It is important to keep in mind that the conditions of the real world are different, but nevertheless an examination of conditions in the ERE is useful in explaining the production structure concept and allows us to distinguish between entrepreneurial profit and interest. As noted above, since there is perfect certainty in the ERE, no entrepreneurial profit or loss exists. Time preference however exists in the ERE, and hence there exists interest. The importance of isolating interest will become clear further below.
Capital and The Role of Capitalists
Once more time consuming production processes involving several stages are engaged in, there is on the one hand the expectation of a higher output of final goods, but on the other hand, a longer ‘waiting time’ until this higher output emerges. How long a waiting time an economic actor is willing to accept is a matter of his personal time preference. A high time preference means he will allocate more of his income to present consumption, a low time preference means that he will allocate more to saving and investment. In the market economy, a society-wide rate of interest will be established by the value scales of the individuals in the ‘time market’. The process is in principle no different from that governing other exchanges in the economy in which prices emerge. For every individual actor there are various interest rates at which he may be a supplier of present goods against a claim to future goods, rates at which he will be a demander of present goods in exchange for future goods and rates at which he will abstain from participating in the time market altogether. This varies from individual to individual, and even a single individual’s role may vary according to changes occurring in his available cash balance over time. The interest rate at which the largest amount of transactions can take place, i.e. where supply and demand intersect, is the society-wide interest rate. In the ERE this ‘pure’ interest rate will tend to be uniform across all stages of production and all different production processes. This is a result of the fact that if the spread that could be earned in certain stages or lines of production were higher than in others, the prices of factors and lines where the higher returns are available would be bid up, with the resources being withdrawn from the factors where the lower spread pertains – this would continue until all interest rate spreads are uniform again (the tendency toward such uniformity is also observable in the real world). What capitalists pay for the factors of production is their discounted marginal value product, and in the ERE the factors are all allocated in such a way that this discounted marginal value product is the greatest possible. In the real world factors will often be under- or overpriced, which gives rise to entrepreneurial profit and loss. We will look more closely at the concept of the discounted marginal value product in a future article, but here is a bonmot by Rothbard in this context that is pertinent to what follows below: “Owners of land and labor factors receive a discounted share [of the marginal value of their product], but owners of capital (money capital) receive the discount.”
In principle it is possible for everyone to adopt either a specific role, or several roles in the economy concurrently. As an example, a person may be working for wages and at the same time invest his savings in an enterprise. Moreover, the differentiation between ‘land, labor and capital’ in production must not lead one to the conclusion that capital as such earns an independent return. Capital goods, or the ‘produced factors of production’ are the result of the purposive mixing of land and labor after all (see also the quote by Richard von Strigl above). So how and why do capitalists earn a return?
What they earn is in fact (leaving entrepreneurial profit aside) the interest rate spread between present goods and future goods. In effect, capitalists purchase future goods from the originary factors and the capitalists of the next higher production stage by advancing present goods to them. Remember that a complex production process involving several stages involves a long waiting time. Capitalist relieve the factors of production the services of which they hire or purchase of this waiting time. In other words, the remuneration for being a capitalist (a ‘saver and investor’) consists of the interest rate – the agio of present goods vs. future goods.
Note here that while the payment of present goods is in the form of money, which can be exchanged for other goods, money is at the same time only a ‘veil’. The pool of real funding must be large enough to enable the funding of the production processes concerned, i.e. there must be a big enough pool of real goods to sustain those involved in lengthy production processes until these processes come to fruition and the consumer goods they are ultimately intended to produce emerge.
One can easily imagine this relationship by considering the following: let us say Smith is a baker producing bread. He sells all the bread he produces in excess of his own bread consumption for money. Note that this production he has sold is his contribution to the economy’s subsistence fund – the money he receives in return is so to speak representing this contribution. He then decides to use half of the money he has received for his own consumption purposes, buying various consumer goods and saves half in order to invest. In effect he has exchanged half the bread he has sold for the contributions of other producers to the economy’s pool of real funding – his consumption is fully ‘backed’ by preceding production. The other half of his income which he saves is the extent to which he abstains from present consumption – hence the consumer goods he could have consumed still exist. He now invests he saved portion of his income. Say half of the investment goes toward maintenance of his oven and the other half is lent out in the loanable funds market to other capitalists investing in other lines. He has thereby ensured the maintenance of his own durable capital, while the remainder can be used by others for other investment purposes. The important point here is that Smith’s activities for which he uses his money income are all ‘backed’ by his preceding production, i.e. his contribution to the economy’s pool of real funding.
Below is a graphic presentation of a five stage production structure from J.H. De Soto’s book ‘Money, Bank Credit and Economic Cycles’, which depicts the flow of present and future goods (expressed in money terms) in the ERE (i.e., capitalists earn only the originary interest rate). In this diagram, the interest rate is assumed to be approximately 11% per year and each of the 5 production stages is assumed to last one year. This is of course highly stylized and arbitrary for purposes of simplification; in the real world many production process are either faster or slower, and interest income will be accordingly allocated pro-rata.
Also, as a general remark, one does not need to conceive of a production structure going back to the very beginning of time when the first stone age inhabitant had the idea to make a tool. Every production process in the economy has a definitive starting point chosen by an entrepreneur with a definitive goal in mind. The pre-existing capital goods – which we have the foresight and efforts of our ancestors to thank for – are taken as a given (and as previously noted, all capital is imputable to land and labor).
A diagram of a five stage production structure. The consumer goods earn a total income of 100 monetary units (m.u.’s). In the uppermost row we see the remuneration accruing to the original factors (land and labor) at each stage, plus the total interest received by the capitalist in all stages in the right upper corner. The column on the right shows the interest income accrued by capitalists in return for advancing present goods to land, labor and the capitalists of the next lower order stage. The unshaded rows show the total payments received at every stage of production (i.e., the total of present goods advanced to the stage of production concerned in terms of m.u.’s). The total income of land and labor plus the interest earned by capitalists in all stages equals the total received for the final goods – click for higher resolution.
Note here that the fact that these various production processes are continuous and synchronous (as well as unchanging in the ERE, which they are not in the real world) does not alter the role time plays. From the point in time where the production of the first capital good in the highest order stage begins until this particular good has been transformed by going through the various stages until finally the consumer good emerges, the allotted time span must still pass.
Another interesting fact that is revealed in the above example, is that in order to produce consumer goods worth 100 monetary units (m.u.’s) , the total amount of gross savings forwarded in the form of present goods by capitalists in the five stages amounts to 270 m.u.’s (200 m.u.’s to capitalist of higher order stages, 70 m.u.’s to land and labor). If we add to this the 100 m.u.’s spent on consumer goods, then given a synchronous constantly repeating process, the total gross output in a year is 370 m.u.’s. This is why the commonly heard assertion that ‘consumer spending represents 70% of GDP’ is actually not really true. In fact, the gross domestic spending per industry accounts published by the department of commerce reveal that consumer spending is no more than 40% of total private spending in the economy. The reason for the idea that consumer spending amounts to 70% of GDP is that in GDP accounting, all spending on so-called ‘circulating capital’, this is to say intermediate capital goods that are ‘used up’ in the production process are simply not counted. For not entirely clear reasons an exception is made for investment in durable goods. However, from an analytical point of view it is not obvious why they should be accorded different treatment, since durable goods (such as machines) are also ‘used up’ in the production process – only at a slower rate. In the end, the purpose of fixed and circulating capital in the production process is the same – namely to produce consumer goods as the end result of their employment.
Lengthening of the Production Structure
As discussed above, the length of production processes depends crucially on the social rate of time preference i.e., the interest rate. The example of Crusoe and his decision to make a stick showed us that the size of the pool of real funding (his saved berries in this case) needs to be large enough to sustain those in the capital goods industries until the consumer goods their activities will eventually help to produce emerge. The pool of real savings will be the bigger the lower time preferences are, and a lower interest rate signals this (a higher rate signals the opposite). One way of looking at this is also: when individuals save more (i.e., exhibit lower time preference), then they are content with a longer waiting time before they consume, in exchange for being able to consume more in the future.
From the point of view of producers the interest rate therefore helps to coordinate production with consumption schedules. Interest rates are an important factor in economic calculation: the net present value of a future good is higher the lower the interest rate at which it is discounted. This is why investment will shift toward higher order stages of production when interest rates fall. Less is consumed in the present, but these savings are not ‘lost’ to the economy (it makes therefore little sense to worry overly much about consumer spending). When consumers decide to save more, this has a negative effect in the short term on the stages of production closest to the lowest order stage, but a positive effect on the higher order stages temporally more remote from the consumer goods stage. Factors in the higher order stages will be bid up and non-specific factors will be drawn there from their employment in the lower order stages. Further specialization by the creation of additional stages becomes feasible. In ‘Man, Economy and State’, Murray Rothbard has depicted the effect of additional savings on the production structure in two simple diagrams:
A) outlined in blue shows the production structure prior to the employment of new savings. B) outlines in green shows what happens when less is consumed in favor of more savings. The revenues accruing to the lower order stages shrink, but they increase for the higher order stages. In addition, two stages that were previously not feasible have been added to the structure. If we flip the image by 90 degrees, we see that the structure has both lengthened and flattened. The price spreads between the stages have become lower, but remain uniform due to the addition of the new stages.
Here is the second diagram that shows the same effect in a slightly different manner:
The effect of lower consumption, and hence higher savings and gross investment on interest rate spreads and the production structure. The flattening of interest rate spreads in the new structure B) means more income accrues to the higher order stages, and two stages that didn’t exist before have been added.
The new, longer production structure that has emerged after an increase in savings and gross investment will be more capital-intensive than its predecessor. As we will see below, lengthening the production structure in this manner has not altered total spending in the economy, it has merely lowered the interest rate spread between the stages and and has increased investment spending in the higher order stages relative to the lower order ones.
Since this new production structure is more productive, several things tend to happen: firstly, the amount of consumer goods this new structure will produce will markedly increase; and secondly, the prices of consumer goods will markedly fall. As a result, the real incomes of all participants in the economy will rise sharply. Although fewer monetary units are spent on consumer goods, they will eventually buy a far larger amount of consumer goods – by restricting consumption in the present, more consumption becomes possible in the future.
Note that underlying here is also the assumption that there is an unchanged money supply. In the real world, there are a number of industries that have achieved enormous productivity growth where we can see the effect described above in spite of the monetary inflation produced by the fiat money system. Among these industries we find e.g. the computer and telecommunication industries. As Joseph Salerno wrote in the year 2000 when discussing ‘deflation’ (in the sense of falling prices for consumer goods):
“Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. Note that the substantial price deflation in the high-tech industries did not impair and, in fact, facilitated the enormous expansion of profits, productivity and outputs in these industries. This reflected in the fact that in 1980 computer firms shipped a total of 490,000 PCs while in 1999 their shipments exceeded 43 million units despite that fact that quality-adjusted prices had declined by over 90 percent in the meantime.”
Of course in the meantime the relevant numbers such as the number of PC’s shipped and the speed at which they operate have all grown even larger, and prices have plunged considerably further as well. We can state with confidence that this has increased the economic well-being of a great many people. Nowadays we are flooded with additional products that are related to or have grown out of the PC industry and the associated structure of production (think e.g. about tablets and smart-phones) at ever lower prices to no detrimental effect to the industries concerned. In fact, the leading company in the tablet computer industry, Apple, not only provides an affordable product consumers want, it garners large entrepreneurial profits in the process as well.
Below we show the putative lengthened 7-stage production structure as depicted in J.H. de Soto’s book ‘Money, Bank Credit and Economic Cycles’:
The new production structure after consumers have decided to save one quarter (25 m.u.’s.) of their previous 100 m.u.’s of consumption expenditure. As can be seen when comparing this new structure to the one depicted in the first illustration, the interest income per stage is now only about 1.7% per year. The lower order stages 1 to 3 receive a lower share of the total gross investment , but stage 4 and 5 receive higher revenue than before, while stages 6 and 7 did previously not even exist – click for higher resolution.
What happens if we add up the total demand for present goods in this new, longer production structure? We find out that it amounts now to 295 m.u.’s compared to the 270 m.u.’s in the previous, 5 stage example (here the total of present goods forwarded to capitalists in the various stages is 225 m.u.’s, and 70 m.u.’s accrue to land and labor). Together with the 75 m.u.’s spent on consumer goods, we find the total of spending unchanged at 370 m.u.’s – what has changed is merely the ratio of production to consumption. This new production structure, by virtue of being more productive than the 5 stage structure that preceded it, will eventually raise everyone’s real income by enabling a far greater output of consumer goods at much lower prices.
Above we have stressed that while money is a sine qua non for a complex economy due to facilitating indirect exchange and making economic calculation possible, it is ultimately only a ‘veil’ with regards to production. What actually funds production is not money, but the pool of real savings. This is why interest rate manipulation and credit expansion by means of money created from thin air are harmful and lead to the emergence of boom-bust cycles.
A lower interest rate signals that it is profitable to divert factors of production to higher order stages and add new stages of production. Alas, as Mises said in ‘Human Action’, ch. XX:
“The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.”
What causes such ‘overestimates of the available supply’ is an artificially lowered interest rate and an expansion of the supply of money and credit. Obviously, if it turns out that not enough real funding for longer, more complex and time consuming processes of production is available, then some of these processes will have to abandoned. The production structure must be shortened again to produce what is most urgently needed and allow the pool of savings to be rebuilt. Some factors of production will be easily transferred and put to new uses (as a rule, this depends on their degree of specificity), while others will have to be liquidated or must lie idle due to a lack of complementary capital goods or otherwise sensible alternative employment. This process is is known as the bust – the recession, or depression. The economic downturn will be the worse the more capital malinvestment has taken place before it begins. In this context the current secular bust must be seen as the outcome of an especially egregious credit expansion boom period that preceded it.
As to what needs to be done about it: nothing. Or let’s rather say, there is something that can be done: stop inflating, stop manipulating interest rates, stop deficit spending and lower the institutional and regulatory barriers that stand in the way of a rapid reorganization of the economy along lines that conform to actual consumer demands.
In this article we could only represent a rough outline of capital theory – many things we have only mentioned in passing or not at all. However, this post will hopefully serve as an inducement to engage in further reading and help readers understand our opposition to interventionist economic policies.
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