A Theory of Capital

Time, savings and economic progress

The economics of Keynes and the Chicago monetarist school are historical outgrowths of a school of economic thought that has remained curiously untouched by the revolution of subjectivist economics that began with the publication of ‘Grundsätze der Volkwirtschaftslehre’ (‘Priniciples of Economics‘) by Carl Menger in 1871.

 

Carl Menger: Author of ‘Principles of Economics’ and founder of the Austrian school.

Menger is the founder of the Austrian school, and his work completely revolutionized the understanding of value, utility, money, exchange, prices and market processes. It is possible that the language barrier played a role in the slow acceptance of this new theory in the English-speaking world, but for the purpose of this article suffice it to say that Menger was the first author to recognize that there are goods of different order, by differentiating between lower order goods (consumer goods) and higher order goods (capital goods).

The major difference between the Keynesian and Monetarist approach to economics and the Austrian approach is indeed the complete lack of a theory of capital in the former, which regard capital as a mythical homogeneous fund that sort of self-replicates. This mechanistic conception, which looks at economic activity as a simple circular flow model between aggregates and disregards the factor of human action and the concept of the inter- and intra-temporal coordination of production, is unable to explain the recurrence of booms and busts, and thus unable to predict them.

The concepts underlying the Austrian capital theory are easily grasped by considering the example of Robinson Crusoe on his island, first used by Eugen von Böhm-Bawerk in ‘Kapital und Kapitalzins: Positive Theorie des Kapitals’ in 1889 (‘Capital and Interest: A positive Theory of Capital‘) and later also used by Murray Rothbard in ‘Man, Economy and State‘. The example illustrates the basic tenets of praxeology (the study of human action), and can be viewed as the initial building block of the theory of capital. It goes as follows:

Robinson arrives on his island, and initially his only means of subsistence are edible berries which he collects by hand. In other words, Robinson possesses no capital, and is engaged in the production of a lower order, or consumption good. There is a single stage of production, the collection of berries. It takes him eight hours per day to collect enough berries to ensure his survival.

After some time of doing this, Robinson’s inner entrepreneur awakes and he has an idea: suppose, he thinks, I were to fashion a wooden stick a few meters long. I could then collect berries currently out of reach, as well as speed up the berries collection process by striking the berry bushes with more force than I can currently do by hand. He reckons that in this manner, he could easily double his production of berries.

However, there is a problem: making the stick takes time – time during which he must interrupt his daily berry collection activity. What shall he eat?

It becomes evident that in order to make the stick, Robinson will first have to make a sacrifice and save some of his current production. If for instance the stick making process takes five days, he will have to save enough berries to sustain him for five days. At this moment, Robinson faces a choice on his personal scale of values: namely whether or not he is prepared to forego some of his present consumption in exchange for the promise to be able to consume more in the future.

Since attaining his future goal of being able to produce more berries in the same time interval (or the same amount of berries in a shorter time interval) requires a sacrifice, he must attach a higher value to the attainment of this future goal than to his present consumption.

A present good is always more valuable to an economic actor than a future good – the ratio between these two evaluations – the value assigned to a present good compared to that assigned to the future good, is the natural, or originary rate of interest. It is also evident that no economic progress can occur in terms of Robinson’s berries collection enterprise, unless he decides to save.

We can furthermore state: if Robinson decides on adding a stage of production, i.e. the production of a higher order, or capital good, namely the stick, he is engaging in a more time-consuming production process than previously. Robinson is about the lengthen the structure of production, by adding one stage (the stick production) to it. This time element is very important.

Note here that Robinson is faced with the problem of inter-temporal coordination: he must correctly estimate the time it will take to fashion the stick, so that he saves enough berries to be able to see the process through.

 

Robinson Crusoe, pondering the creation of a capital good. Shall I fashion a stick?

 

The entire principle of capital theory is embodied in this example: in order to achieve a future goal that the actor values more highly than his present consumption, he must save enough of his present consumption to be able to engage in a more lengthy, but ultimately more productive, production process. It is the combination of saving and entrepreneurial activity that makes the more complex and longer, but ultimately more productive processes of production possible. The more stages are added to a production process, the more time consuming and the more productive it will become.

By engaging in the production of the stick Robinson will ultimately be able, due to his higher productivity in the berry collection enterprise, to attain other, at present (i.e., prior to the making of the stick) still further away, even impossible goals. Since he will be much more productive once the stick has been produced, he will have more time which he can in turn spend with achieving other objectives, such as fishing to vary his diet, or building a hut to be protected from inclement weather.

We can already see by this simple example that capital is not just a monolithic blob: its creation takes time, saving , entrepreneurial activity and an inter- temporal coordination effort. What is also evident is that what is initially saved are the unconsumed final goods from prior production – this is to say, real resources that are required to sustain the persons engaged in the production of the capital good during the time period the production takes place. We can state: there can be no economic progress without saving.

 

The GDP Accounting Fallacy

In the modern market economy, a lattice-work of highly complex production structures and plans of enormous length are in place, constantly adapted by entrepreneurs and capitalists based on their expectations of the future and the information imparted by prices. It is noteworthy in this context that the modern conception of a nation’s total economic output, or GDP (Gross Domestic Product) , simply ignores all the stages of production that take place prior to final goods output. Calling it a ‘gross’ product is in fact a serious misnomer. As George Reisman explains in ‘Standing Keynesian GDP on its Head: Saving, not Consumption as the main Source of Spending‘:

 

“Productive expenditure, the sum of the expenditures for capital goods and labor by business firms, almost certainly not only exceeds consumption expenditure but does so by a wide margin. The truth of this proposition can be inferred from common knowledge about the size of business profit margins.”

 

As it were, the truth of this assertion can be confirmed by looking at the BEA’s ‘Gross Domestic Product by Industry Accounts‘. As can be seen by these data, the total of economic output by private industry during 2008 (the most recent year for which the statistics are current) amounted to $23,5 trillion – far more than the official GDP of roughly $13,5 trillion. Another revelation, which will be startling for most readers, is the fact that the by far biggest sector of the economy in terms of gross output is the manufacturing sector.

As Reisman further states:

 

“[…]Keynesian macroeconomics is literally playing with half a deck. It purports to be a study of the economic system as a whole, yet, in ignoring productive expenditure, it totally ignores most of the actual spending that takes place in the production of goods and services. It is an economics almost exclusively of consumer spending, not an economics of total spending in the production of goods and services.”

 

In fact, contrary to the popular assertion that ‘consumer spending represents 70% of economic activity’ the truth is that consumer spending represents probably no more than 35% to 40% of all economic activity. The popular consumption-focused conception of the economy has the great disadvantage of giving respectability to the Keynesian ‘under-consumption’ theory, and leading to economic interventionism focused on increasing consumption as a panacea against the economic slump.

As Reisman notes, the bulk of spending in the economy in fact depends on saving:

 

“In Keynesian economics, saving appears as mere non-spending. This is because essentially the only spending that Keynesian economics recognizes is consumer spending. Thus, if funds are earned and are saved rather than consumed, it appears to Keynesians that they are simply not spent, i.e., are hoarded. It is on this basis that Keynesian economics describes saving as a “leakage.” Yet the truth is that the only way that funds expended in the purchase of consumers’ goods can ever subsequently show up as productive spending for capital goods and labor is if and to the extent that the business recipients of those funds do not consume them. Only by saving the funds in question can they have them available to make productive expenditures of any kind. Productive expenditure depends on saving.”

 

This can be illustrated further by looking more closely at

 

The Structure of Production

In order to better understand the economy’s structure of production, we will make use of the construct of the ‘evenly rotating economy’ (ERE). Murray Rothbard explains this concept in ‘Man, Economy and State’ as useful for elucidating economic theory, in spite of the fact that it is not representative of the ever-changing, dynamic real life economy. The ERE is an economy in which a ‘state of equilibrium’ pertains, a state toward which all economic activity strives, but which can in real life never be attained, as the circumstances, expectations, plans etc. of economic actors, and the data available to them constantly change. As we have previously mentioned, the economy is better understood as an organism rather than a machine, an organism made up of individuals whose interplay of economic activity creates a spontaneous order. Nevertheless, the ERE has its uses as a construct that allows us to better explain the processes of the market economy.

According to Rothbard:

 

“After data work themselves out and continue without change, the rate of net return on the investment of money capital will, in the ERE, be the same in every line of production. If capitalists can earn 3 percent per annum in one production process and 5 percent per annum in another, they will cease investing in the former and invest more in the latter until the rates of return are uniform. In the ERE, there is no entrepreneurial uncertainty, and the rate of net return is the pure exchange ratio between present and future goods. This rate of return is the rate of interest. This pure rate of interest will be uniform for all periods of time and for all lines of production and will remain constant in the ERE.”

 

In short, in the ERE we leave entrepreneurial profit – the ultimate motivator of entrepreneurial activity – out of the depiction of the production structure , which means that the profit accrued at every stage of production equals the natural interest as dictated by time preference. Before we proceed to the diagram depicting the production structure, a few more explanations.

As we have seen in the Robinson Crusoe example, savings make it possibly to expand the production structure by adding new stages to it that produce higher order, or capital goods. The further removed a stage is in time from the final, or consumer good, the higher the order of the goods produced at that stage. Evidently, is is the size of the pool of savings – this is to say the pool of unconsumed production – that dictates how many stages can be profitably added to the production structure.

Since a longer production process consumes more time, it requires a larger pool of unsold final goods to sustain it and bring it to a successful conclusion – at the end of which there will be a larger output of consumer goods than was possible prior to the lengthening of the production structure.

We see from this how the time schedules of consumers and producers are coordinated by time preference. A lower time preference will result in more savings being available, which allows for more time-consuming and ultimately more productive production processes to be engaged in.

There will be more present goods available that capitalists can pay to the original factors (land and labor) in exchange for the future goods that these factor produce. A lower time preference means also a lowering of the natural interest rate, which is to say that future goods are higher on the value scale of consumers than present goods than they were prior to their decision to engage in more saving.

We can also see from this why when this happens (i.e., the amount of savings increases and the natural interest rate falls), the investment in stages further removed in time from final goods becomes more profitable. The present value of a durable capital good is the discounted value of its future rents, so that its present value increases the lower the interest rate is that is used in the discounting process. Thus the profits attainable in the stages of production furthest removed in time from the final goods stage rise when the natural interest rate falls.

At the same time, the decision of savers to defer some of their present consumption in favor of saving will exert downward pressure on the prices of consumer goods and make the stages of production closer to consumption comparatively less profitable. This enables the release of resources employed in these stages to the now more profitable stages further away from consumption, which due to their higher profitability can bid resources away from the lower order stages.

The diagram of a production structure in the ERE below is taken from Jesus Huerta de Soto’s book ‘Money, Bank Credit and Economic Cycles‘.

 

Outline of a 5 stage production structure in the ERE – the right hand side column depicts the profits earned by capitalists at each stage of the production process, which in the ERE equals the rate of interest and is the same at every stage (in this case about 11% p.a.). The top row shows the net amounts earned by the owners of original factors (land and labor) of production at every stage. The 70 units of income accruing to the original factors plus the 30 units earned in toto by capitalists/entrepreneurs add up to the monetary value of the final goods in the lowest order stage at the bottom. In GDP accounting, only the ‘value added’ as embodied in the final goods is counted (i.e. the 100 monetary units of total net income, equaling the amount of consumption of final goods). However, we can see here that the total value of present goods advanced by entrepreneurs over the course of the entire 5 stage process depicted above amounts to 270 monetary units. Thus the total gross economic output is 270 units in advancement of present goods plus the net income of 100 units (i.e. the value of the final goods). In short, the gross output amounts to 370 monetary units. The entire value of intermediate inputs is simply not considered in GDP accounting – click to enlarge, chart taken from: ‘Money, Bank Credit and Economic Cycles’

 

In the above context, George Reisman has demonstrated that it is in fact mathematical nonsense to assert that the value of final products counts anything but the value of these products themselves. In his appropriately entitled essay “The Value of “final products” counts only itself”(pdf), which we highly recommend for further reading, Reisman states:

 

“The value of final products counts only itself and not the value of so-called intermediate products. The prevailing, contrary belief entails a twofold violation of the laws of mathematics — namely, the impermissible discarding of essential terms of equations and then the addition of the remainders of equations that are mutually exclusive and therefore not properly subject to addition. It follows that in order to count the values of the so-called intermediate products, one must go out and count them, because they are not counted in the value of the final product. Despite prevailing belief, counting the value of intermediate products does not represent “double counting.”

 

We see that the fixation on ‘under-consumption’ and increasing ‘consumer spending’ that underlies much of today’s economic policy is entirely unwarranted. It is saving, rather than consumption, which enables a higher standard of living.

 

George Reisman: ‘The economy consists of much more than just consumption’.

Image credit: Wikimedia Commons

 

The pernicious Effect of Credit Expansion

It should also be clear from the above that there is a fundamental difference between the effect voluntary saving of preceding production has on the economy and the effect exerted by an expansion of the credit and money supply. By increasing the amount of fiduciary media, the banking system creates the illusion that there are more savings available than there are in reality. As soon as ‘money from thin air’ is used in exchange, we can say an exchange of ‘nothing for something’ is taking place, since there is no preceding saved production that is ‘backing’ this new money.

Newly created deposit money does not enter the economy all at once and at every point simultaneously. If that were the case, the effect would be ‘neutral’ – all prices would rise by the same amount simultaneously. We would certainly all be aware that we have not truly become richer if the amount of our cash balances were to double overnight and all prices were to double concurrently, but it would be easy to adapt to this new circumstance.

However, the appearance of additional amounts of money from thin air, by artificially and temporarily lowering the market interest rate below the natural rate, leads to a distortion of relative prices within the economy’s production structure. Stages of production further away from final goods suddenly appear more profitable, and investments in these stages will accordingly be undertaken. However, since there were no real, voluntary savings added, the time preference of consumers has not changed, and the seeming profitability of these new investments is in reality a mirage.

The necessary sacrifice of saving, which allows more present goods to be advanced to original factors in exchange for future goods has not taken place. The real resources necessary to sustain the new investment projects thus do not exist. A boom ensues, but the boom actually impoverishes us, as capital must in effect be consumed to keep it going. The investments undertaken on the basis of the credit expansion will sooner or later be revealed as malinvestments.

Once the artificial boom ends, entrepreneurs are faced with having to redirect (where possible) or liquidate the malinvested capital. The bust is actually the process of recovery – it is the time when the structure of production is rearranged to once again properly coincide with the true wishes of consumers.

More money from thin air doesn’t make us any richer. When additional fiduciary media are created from thin air, this does not change the amount of real savings or the amount of capital goods in existence. It only sets a boom with the attendant malinvestments in motion, and real capital will be consumed.

 

 
 

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