Capital theory
Over the last few years
it has become increasingly obvious that the development
of modern economic theories may have intensified
boom-and-bust cycles, rather than achieved the stated
objectives of price and economic stability. Furthermore,
there is much that Keynesianism and monetarism seem
unable to explain.
These dogmas are purely
macroeconomic and are based on assumptions that an
understanding of microeconomics can easily disprove. The
former is in the heads of academics, the rest of us
exist in the real world of the latter. It has to be
remembered that Keynes was a mathematician and academic;
when he developed his economic theories, microeconomic
theories were being refined in German, so this
information was not easily available to him, even if he
had wished to understand them. Monetarists share many of
their theories with Keynes, and have even admitted
macroeconomics does not offer adequate explanations.
Britain’s economic success in the nineteenth century was
a mystery to Milton Freidman. The Spanish monetarist,
Pedro Schwartz, wrote in 1993 “There is no proven theory
of cycles: it is a phenomenon we simply do not
understand. However with money becoming elastic, and
recessions leaving us speechless, it is easy to
understand how we macroeconomists became unpopular.”[i]
Indeed. But there is a
microeconomic theory that clearly explains where modern
macro dogmas go wrong: capital theory as developed by
the Austrian school.
Put simply, this capital
theory states there is a fundamental difference between
capital investment financed by an increase in savings,
and capital investment financed by bank credit. To
understand why, it is helpful to consider a theoretical
example of each.
First case:
Capital investment financed entirely from savings
The amount of money
allocated to consumption will obviously fall to fund an
increase in savings. This lower consumption puts
downward pressure on consumer product prices,
intensifying price competition. The message from the
high street to the manufacturing chain is to lower unit
costs and innovate, all of which requires investment in
capital equipment. At the same time, the increase in the
level of savings drives down interest rates, and funds
from increased savings are available for this capital
investment. Manufacturers are therefore able to invest
in more efficient plant and equipment at attractive
rates. Furthermore, new manufacturing processes and
specialisations become viable, so new links in the
capital goods chain are established.
It is worth noting that
the increase in savings reduces the value of business at
the retail end of the consumer goods chain, relative to
the value of capital goods used in the manufacturing
process. This arises from lower relative returns from
retailing activities, and a rising value of the income
stream generated by investment in capital goods as a
result of lower interest rates. There is therefore a
fundamental shift in economic emphasis away from
consumer goods towards capital goods. The result is that
a continual process is set in motion that leads to
cheaper, better end-products, manufactured by a bigger,
deeper pool of manufacturing industry.
It is important to note
there is no “crowding out” effect, since labour and
other economic resources are gradually released from
activities closer to the finished product, to be
redeployed upstream in the growing number of
manufacturing specialisations and by manufacturers of
capital goods.
This process continues
into the longer term and labour costs tend to increase
as prices decline. Rather than reduce wages, employers
throughout the manufacturing chain will continue to
invest in capital equipment to reduce manufacturing
costs. The result is that employees, who are also
consumers, become wealthier from a tendency for prices
to fall relative to their income. Furthermore, the
growing accumulation of their savings is enhanced by the
rise in its purchasing value and is more than sufficient
to comfortably finance their retirement, health and
leisure.
Second case:
Capital investment financed entirely by credit
When banks increase the
availability of credit, interest rates are lowered for
the same reason as when savings are increased. The
difference is that the expansion of credit lowers
interest rates below their natural rate, and there is no
reduction of consumption to accommodate new investment.
The two situations are therefore fundamentally
different.
The initial effect of
lower interest rates is to stimulate loan demand from
businesses, and also from consumers for the purchase of
durable goods. Lower interest rates also boost the
present value of capital goods making investment in them
more attractive, since the discounted value of their
output is increased. Businesses are therefore encouraged
to invest in greater production. Furthermore, lower
borrowing costs make marginal investment propositions
more attractive, persuading entrepreneurs to invest in
new processes.
It should be noted that
even though the credit is made available, the necessary
economic resources have not be released by lower
consumption – as in the First Case above. This leads to
a number of problems:
1.
Labour and other production costs rise as the
borrowers of this new credit compete for production
resources that have not been released, since there is no
balancing fall in consumer demand. To obtain these
resources, they have to be “bid up”.
2.
The redeployment of labour and other resources
from final assembly to earlier stages of production
tends to be disruptive and create supply shortages,
because there is no slack in the system. At the same
time an increase in wage rates, due to the general
increase in demand for labour, in turn increases demand
for consumer goods. The result is that prices of
consumer goods can be expected to rise as fast, if not
faster than wages.
3.
An illusion of entrepreneurial prosperity is
therefore generated by the difference between
artificially low financing costs and now rising consumer
prices. The growing tendency for consumer prices to rise
faster than the costs of production enhances the
illusion. The consequence of the illusion is that
businesses themselves contribute to the increasing
levels of demand, driving up the prices of goods
further.
4.
The rising prices of consumer goods benefit
businesses in the stages closest to consumption;
meanwhile those farthest from consumption have the least
benefit, yet face general increases of the cost of
production. Many of these businesses become unviable,
and economic resources tend to return to the businesses
in the stages closer to consumption. The economy becomes
more consumption-oriented as a result, and looses the
depth of production activities associated with long-term
industrial stability.
Put another way, these
problems generate a growing inflationary effect, because
price rises tend to outstrip the rise in wage costs.
Investment in capital goods becomes less profitable than
employing labour, whose cost does not rise so fast as
that of finished articles. Instead of the economy
enjoying the benefits of rising living standards from
falling prices relative to wages, it experiences the
inflationary opposite. Instead of workers being able to
save for a comfortable retirement, their fewer savings
are eroded by inflation, and become insufficient for
retirement through a fall in purchasing power.
A boom generated in this
way through an expansion of credit is clearly
unsustainable, and it is followed by a bust triggered by
the following processes:
1.
Sooner or later, the pace of credit expansion
stops accelerating sufficiently to keep interest rates
below what they would have been if the credit creation
had not occurred. Interest rates then rise to
pre-stimulus levels or even higher. They usually go even
higher, because distressed borrowers will be prepared to
pay any rate to complete unfinished capital projects,
and lenders begin to anticipate further inflation and
build this into bank lending terms.
2.
Losses develop in the capital goods businesses
most removed from consumers and gradually spread along
the production chain. The result is that investment
projects are abandoned, factories closed, and workers
laid off. Pessimism spreads with the notion that an
inexplicable economic crisis has happened after people
had become to believe in the boom.
Economies that are
driven by the creation of credit experience
progressively larger cycles of disequilibrium, because
the inevitable response after the bust is to promote yet
more credit to alleviate the effects. The logical end of
this repetitive process is a build-up of economic
distortions that can only be resolved by a final bust.
Historical
confirmation
The two cases summarised
briefly above represent the difference between an
economy based on sound money and one financed through
inflation. They confirm that government and central bank
policies based on macroeconomics and without any regard
to the actual microeconomics have been the origin of
boom-and-bust cycles. Furthermore, there are historical
examples that confirm Austrian capital theory works in
practice.
Britain operated under a
gold standard from about 1820, after the Napoleonic Wars
until the First World War, a period of some 90 years.
During that time, prices fell by about 25%, yet
Britain’s economic strength was such that she became the
most powerful trading nation in history.
More recently, whether
through accident or design, both Germany and Japan
developed post-war economies driven by savings. These
economies featured strong capital goods industries, full
employment, low inflation, strong currencies, and high
levels of individual wealth spread throughout society.
They have proved that deflationary growth associated
with real savings is the ideal economic outcome, and in
the process their apparent economic miracle became the
envy of nations living on credit. They have disproved
the macroeconomic theories of Keynes and the
monetarists, who quite simply do not admit that you
cannot substitute real savings with fiat credit.
Concluding remarks
Capital theory provides
confirming evidence that Keynesianism and monetarism are
thoroughly destructive, have been responsible for the
economic ills of the Anglo-Saxon countries, and for the
persistent inflation that led to the pensions crisis. US
and UK governments are now on the hook for trillions of
dollars and pounds to replace private savings that were
discouraged through high levels of taxation (remember
the investment income surcharge?), artificially low real
interest rates, and then all but destroyed through
inflation. In spite of this, economists advise yet more
unsound money, by means of “quantitative easing”, or
through the benefits of “exchange rate flexibility” –
for which read only downwards.
We now have an
microeconomic explanation for the economic crisis that
built to a peak in the late 1970s, when the cycles of
increasing credit creation were halted at the time of
Reagan and Thatcher. But it was not long before the Fed
and the Bank of England resumed their old ways, leading
us again to a series of increasingly violent
credit-driven cycles of boom-and-bust. The build-up of
false credit today is greater than ever, and stopping
the merry-go-round of ever faster credit creation will
probably bankrupt the entire banking system.
So capital theory
provides a credible explanation of why the US and UK
economies in particular are in such deep trouble today.
1 July 2010
[i] As translated and quoted
in de Soto’s “Money, Bank Credit and Economic
Cycles”.
