v. 2.0

 

  1. Introduction

An important view of the Austrian school of economics is represented by its theory of capital. The Austrian Capital Theory (henceforth ACT) is used to explain the economic growth/retrogression and the processes developing during the course of the business cycle. The aim of the present article is to critically evaluate the suitability of ACT to reflect and explain the development of an economy. In particular, it will be argued that:

  1. The ACT in its standard form is not able to include the main bulk of capital present in an economy, in particular the fixed capital, and because of the latter fact cannot qualify for a general capital theory as such.
  2. The ACT in its standard form cannot account for the fact that an economy produces not only consumer goods but also capital goods.
  3. The ACT presupposes that net saving must be present for the economy to grow. It will be shown why the latter requirement is not a necessary one.

An alternative economic view will be presented which does not suffer from the above-listed inadequacies.  The discussion  will be limited to the normal growth/retrogression conditions of an economy under invariable money only. Since the points that are discussed affect the basic capital structure of the economy the ability of the standard treatments of ACT to represent the credit cycle process will also be put into question, but the latter point will not be explicitly discussed.

 

  1. Overview of the traditional ACT

The ACT is typically depicted as a sequence of stages which represent the movement of intermediate goods from the original means of production (land and labor) to the durable produced goods sold to the consumer. A typical representation is shown in Figure 1.A good begins being produced from the highest order stage, where it is created entirely from the original means of production. Then it passes down the structure to the next lower level as an intermediate product where additional value is added to it again from the original means of production. In this way the good gets improved in every subsequent stage until it becomes a completely finished good, ready for consumption in the last stage, where it gets sold to the consumer. When a good passes from one stage to the other it is being exchanged for money. The flow of money is naturally from the lowest order stage up to the original means of production. The monetary stream is started by the consumers when they buy a particular good and then this money goes up stage by stage. The stages themselves represent the different types of processing the particular good undergoes in time and each stage is supposed to embody a group of similar processes in an economy. Thus each stage takes a particular unit of time which is assumed to be the same for the sake of simplicity in the graph. At each stage a monetary profit (not shown) is generated which accrues to the particular producers. Since more and more original means of production are added when traversing the graph in downwards direction the monetary value of each stage grows.

A more detailed description can be found in the works of Hayek (1967),  Rothbard (2009) and De Soto(2012) which will be used as a base for the present discussion. The above given, general description however must be  sufficient for the purposes of what we intend to achieve.

 

3. Structural problems embodied in ACT

 3.1. The inadequacy of ACT to represent fixed capital goods

When we inspect the given ACT graph we cannot avoid noticing that all the goods represented are intermediate (circulating) capital goods. The so called fixed (durable) capital goods are not visible anywhere on it. The latter fact has been acknowledged by Hayek (the main contributor to the theory) and never corrected by him (Repapis 2011). What this means is that originally durable capital goods have not been considered at all, i.e. the theory has disregarded their existence entirely. Later  the theory was patched so that durable capital goods can be taken into consideration (e.g. Skousen (1990)). The real problem is that ACT is a flow diagram. In other words it depicts only monetary transactions and their outcomes. Fixed capital however is not exchanged when used in production and thus it is not directly representable on it. From another point of view the ACT graph shows only the distribution of the amount of money present in an economy. Fixed capital goods used in production (i.e. plants, machinery, etc.) have market prices but these prices are not included in the monetary supply of the economy. In fact if we artificially add the current market prices of all the capital (fixed and intermediate) together we will get a number which surpasses the amount of money in the economy by many multiples.

In view of the above, if we wish to represent fixed capital on a standard ACT graph we must make sure that it follows the rules the theory is based on. In particular this would mean that fixed capital can be resolved into factors of production, i.e. the intermediate capital goods and original factors of production used for the creation of the good. These factors of production could already be added to the ACT graph, i.e. they are representable by it. This would be the only correct way to reuse and amend the existing theory instead of creating an entirely new one.

The real problem with the above approach is that the operation of imputation (resolving fixed capital goods into circulating capital goods and original means of production) must not be taken for granted. Here we intend to show that in the context used such an operation is not allowed and therefore fixed capital goods cannot be represented by ACT. In other words, that ACT, contrary to its claims, is not able to account for the existence of fixed capital entirely.

Durable capital goods can be resolved into factors of production only during the process of their creation. After a durable capital good has been produced (i.e. it is not improved any more) this is not possible. But since fixed capital goods supposedly represented by ACT are goods out of production (in use) they cannot be put on the standard ACT graph (Figure 1).

During the process of production businessmen use economic calculation in order to make sure that the product they create will be accepted by the market. From their target product price they impute appropriate factor prices so that production can be achieved at a profit. In other words businessmen use imputation during the whole process of creation of the particular good. In this way they take the available market information into consideration. As an example a businessman, when deciding to produce a new brand of cheese tries to guess first at what price the cheese could be sold, and then computes if this is possible by varying/playing with the factors necessary for its production, i.e. he calculates the expenses for labor, milk,etc. based on the current market prices. And if this calculation shows that profit can be achieved he may decide to undertake the risk of the new project.

Once a good stops being improved any more, the process of imputation also stops however. It is useless for the businessman to view a kilogram of cheese as 7 liters of milk, other separate ingredients and a particular amount of labor. The reason is that the production of cheese is an irreversible process. The amount of labor used is gone forever, the depreciation of the tools used in production cannot be undone and there is no way to get the milk back from the cheese. What that means is that imputation (back to the original factors of production) is not used any more by the market once the production of the capital good has been completed. The market views the produced good as a separate, new, indivisible product, which can only be assessed as a whole.  In other words, after a good has been produced, the cost of production becomes irrelevant.  An additional complication is that ACT presupposes that the finished durable good is used later in time, i.e. the durable capital good must be resolved into factors of production which are not the original ones used during its production. In particular:  by the time a ready-made machine is used the price of labor has changed, the amount of labor necessary for its production has decreased due to technological innovation, other factors of production have changed, disappeared or new ones have been added. There is no known connection between the factors of production in a time period which succeeds the production of the capital good in question and the good itself. Thus the task to resolve a ready-made capital good into totally unrelated factors of production is an impossible one. In short: such type of calculation is not done by the market in general and what is more important, it is not possible for the market to do it. Let me give an example in order to elucidate the above: A picture of Picasso or Leonardo da Vinchi is used as a capital good, e.g. displayed in a private museum for profit. The picture derives its high price from the fact that it has been created by Picasso himself. But Picasso is not among the living any more and we cannot resolve the price of the picture into his labor. A proper substitute simply does not exist. The same applies to the canvas and paints used. Such ones are not produced any more (and will never be produced). In short, it is impossible to resolve Picasso’s picture into something meaningful. This is an impossible calculation.

To summarize all of the above: ACT cannot accomodate fixed (durable) capital goods in itself. The reason is that durable capital goods out of production are not resolvable into intermediate products and original means of production. But such an imputation is the only proper way to include fixed capital goods in ABCT. What immediately follows is that ACT disregards entirely all the fixed capital available in an economy. But a theory of capital which does not consider most of the capital in the economy cannot be used to describe economic processes. Thus the above argument is enough by itself to invalidate ACT entirely.

 

3.2. The inadequacy of ACT to account for the production of durable capital goods

 When we critically evaluate Figure 1 we cannot avoid noticing that the only product which exits from it is consumer goods. An economy, however produces durable capital goods as well and their production must somehow be accounted for. The standard ACT supposedly resolves the durable capital goods into factors of production and places them on the ACT graph. Thus the production of durable capital goods happens implicitly. It is hidden from view and not explicitly discussed. The newly produced durable capital goods get “dispersed” on the graph among the different stages and original factors of production and reused until they depreciate completely. In such a way ACT does not distinguish between the processes of production of durable capital goods and their subsequent usage. They somehow coincide and overlap with each other.

As discussed in the previous section such a process of imputation is not allowed. Such economic calculation simply cannot be performed by the market. A consequence from the above is that the production of durable capital goods cannot be accounted for by the standard ACT structure (Figure 1). This means that the production of durable capital goods must be shown explicitly.

As I said ACT does not in fact discuss explicitly how durable capital goods are created. It simply states that the available savings turn into investments when they are used by the entrepreneurs to buy additional original means of production (land and labor) and intermediate products from the prior stages. To quote De Soto (2012, pp. 316): “An entrepreneur who receives these present goods uses them to acquire: (1) capital goods from prior productive stages; (2) labor services; (3) natural resources”. What is missing here is (4) the very well known fact that entrepreneurs use savings to buy durable capital goods also and use them in production. An example is an ore mining company taking a loan to buy a truck to carry its production. In order to elucidate the problem a simplified, specific ACT graph will be used (Figure 2).

At the top stage of the graph iron ore is being mined and transferred to steel plants for flotation and melting in the next stage down. Then it proceeds down to the third stage where different steel parts are being produced. At the lowest stage the already produced steel parts are being used for assembling final/finished products, which will be sold. Imagine for the purpose of the discussion that the last stage is represented by a company, such as General Motors. General Motors (GM) however produces not only cars (a typical consumer good) but trucks also (a typical capital good). In order to produce these cars and trucks GM buys parts from its suppliers from the next stage up. At this third stage we see that the parts produced are mostly specific, i.e. created for a particular car or truck, but still there may be parts which are common to both types of vehicles. When we go up the chain however we see that at the level of flotation and melting plants we cannot generally distinguish  the product created. The steel produced can be used in any product, be it a consumer or a capital  one. Even if we can find some product-geared specificity at this level this does not apply to the top-most stage of the graph (ore mining).

Generally the higher up the graph we go, the less specific the produced intermediate product becomes. Note that GM is used here only as an example of a company producing a mixture of durable consumer and capital goods. All I wished to point out is that such companies exist. In fact at this stage there can be separate companies producing consumer goods only (e.g. cars) or capital goods (e.g. trucks). Still, these companies use similar tools, labor, machinery, even sometimes the same parts from the previous production stages to produce cars and trucks. This is what makes all these companies ( the capital goods producing and the consumer goods producing ones) similar.

The above example serves to show several points. First, that durable capital goods are being produced and this must be accounted for explicitly. And second that we cannot distinguish which part of the original resources (e.g ore) goes towards each of the two types of production (consumer and durable capital goods). In the higher order stages the production is non-specific, which means  that it is not distinguishable/separable.

To summarize all of the above:  Due to our conclusion that durable capital goods cannot be represented on a standard ACT graph it follows that ACT cannot account for their production. Even in its standard description ACT hides the production of durable capital goods from view and does not explicitly discuss how they are being produced. In order to correct the above deficiency a new structure of capital, explicitly depicting the production of durable capital goods must be employed.

 

3.3.  The inadequacy of the presumption underlying ACT that the existence of net saving is a necessary condition for an economic growth

 For an economy to grow what is necessary is that the production of capital goods outpaces the depreciation of the existing stock of capital. Since it is the durable capital goods that depreciate, then what is necessary is that the production of durable capital goods be greater than their depreciation. As long as this condition is met growth is possible. The real question is how exactly the latter happens.

There are two significant treatments of secular economic growth in the Austrian literature. The first one can be found in Hayek (1967), Rothbard (2009) and DeSoto (2012). The second one is described by Garrison(2002). The former description (e.g. DeSoto) requires that the rate of interest goes down with the growth of the economy. In other words, it postulates that the economy as a whole must not only constantly save, but also that the saving as a percentage must constantly grow. In other words, that we need a growing net saving rate. In the latter case (Garrison) the rate of interest may stay the same and the saving as a percentage can stay the same. In other words net saving remains constant and positive. In both descriptions however net saving must exist in order for the economy to grow. Net saving is claimed to be necessary in order to compensate capital depreciation. In other words, what wears out must be recreated and this could only happen if we save some money/products for this purpose.

George Reisman disagrees in (Reisman 1990, ch.15) and develops a way in which an economy does not constantly need net saving in order to grow. He observed that capital goods replicate (recreate) themselves and that is why we do not need to support them with additional savings. What is meant by that is that capital in general produces durable capital goods as well, but the durable capital goods produced can themselves be used to replenish the depreciating stock of capital. Let us represent the problem in the following way: An economy possesses an amount of fixed capital of a monetary value C. Let us also presume for simplicity an amortization rate of 10% per year. Thus at the end of the year we could expect to have a stock of capital of 0.9*C, since 0.1*C value of capital has been worn out. Now we must remember that capital creates durable capital goods too. Let us presume that by the end of the year the original capital C has been able to produce an amount of 0.1*C durable capital goods. These durable capital goods must be added to the existing (already depreciated) capital at the end of the year and we obtain the following: 0.9*C + 0.1*C= 1*C=C, i.e. the same amount of capital with which we started the year. The newly produced durable capital goods have been able to successfully compensate the existing amortization. Thus we do not need savings to support the existing capital. It supports itself by itself.

Note that we presumed that the existing capital produces durable capital goods at exactly the same rate as the depreciation. That is why both cancel out. If however, the economy produces more than 10% of durable capital goods per year the initial capital will grow, or in other words, we will have a progressing economy. And if the economy produces less than 10% of durable capital goods per year we will have a retrogressive economy. Thus if we wish to make sure that the particular economy will grow by itself (without additional savings) we must make sure that it produces at least 0.1*C durable capital goods per year. The latter can be accomplished if we devote enough resources for production of durable capital goods but this can be controlled by the amount of saving. Since consumption and production are always complementary we may produce more by saving more. Thus once a particular level of gross saving is surpassed the economy can grow by itself, without the need of additional savings. Or alternatively, we do not need the rate of interest to continually go down.

What happens is that the level of gross saving present is enough go support the existing stock of capital. We do not need net saving at all. In other words, if a particular amount of savings have been accumulated in the economy then saving out of monetary income  (net saving) can stop. On the average consumers need not save. As Reisman observes what would happen is that the saving of some people, for instance of young people saving for retirement will be compensated by the dissaving of the retirees with the result that no new saving will be produced.  Thus net saving will disappear in the context of an invariable quantity of money.

To summarize:  The standard treatments of ACT presuppose either that the rate of interest must constantly go down ( the strongest condition) or that the rate of interest can stay the same with net saving positive (a weaker condition). As shown above growth is possible even under the condition that net saving equals zero (the weakest condition of all). Existing capital can support itself by reproducing itself. To restate Reisman’s own words, only an initial increase of saving is necessary to start the process of growth. Once this boost is provided we do not need more additional saving. The one we have provided already will be sufficient to ensure the availability of future growth. The latter must be embodied in any theoretical treatment of capital in the economy.

 

4. An alternative capital structure theory

 4.1. Basic structure

 When taking into consideration and correcting the issues with ACT already discussed we are able to create a new structure of the capital of an economy. Figure 3 represents a simplified structure, stripped for the time being from many significant elements in order to simplify the explanation.

There are again four stages in it, but this time each stage represents not only the amount of circular goods passing through it but all the capital at that stage. In other words, each stage embodies the fixed capital goods used in it also. The capital goods are measured according to their monetary value in the current market conditions. Note again that we presume that the amount of money in the economy is fixed. Thus the top-most stage includes everything necessary for iron ore production, i.e. includes machinery, plants, labor, intermediate goods etc. The next lower stage includes all capital necessary for flotation and melting and so on. A small part of the overall capital in each stage flows from the upper stages to the lower-order ones, which is the already discussed intermediate goods. The size of each stage is measured in monetary terms, i.e. it represents the monetary value of all resources employed in it. Note that the monetary value of all stages combined surpasses the amount of money available in the economy by many multiples, since it includes the current market prices of all capital goods (fixed and intermediate). Each stage is assumed to be the same size, but this is just a simplifying assumption. In fact stages can be dissimilar in size, since they can differ in their capital efficiency. On each stage the rate of profit will be the same. Similarly to the original ACT structure the rate of profit will equalize, balance all the stages with respect to each other. The rate of profit will keep the capital in each stage in proper relation to the other stages so that production can go smoothly. So, as usually happens, if a capital saving invention appears in some stage, then in this stage the production will grow, selling prices will go down and profits will decrease. Therefore a part of the capital will switch to the other stages in a search of higher returns with the result that the rate of profit will again become the same in all stages. In the opposite case, if for instance a flood or an earthquake destroys capital at some stage, then the selling prices at this stage will increase and profits will rise, which will create incentives for a capital influx from the other stages. Thus the rate of profit will again go down to the one representative for this structure.  We must note that the rate of profit would take care of the proper investment in capital also. If a temporary over- or under-investment happens at a certain stage, relative to the other stages, then the profits in these stages will change and the corrective process described above will be set in motion. Thus the rate of profit will serve as a regulator of the investment in the economy.

 

4.2. Detailed structure

A more detailed structure of the capital, including the original means of production (land and labor) along with the durable capital goods is presented in Figure 4. It represents the flow of capital. We can draw the same structure in Figure 5 expressing the flow of money. Note the flows of durable capital goods stemming from the lowest stage up to the higher order stages. They represent capital substitution and investment. Again the example is a ore-mining company which buys a new truck to carry its mined ore. For simplicity reasons the durable capital goods and consumer goods are separated only at the lowest stage, although, as discussed above, the product specificity gradually decreases up the graph. In comparison to the standard ACT growth happens not only when more original means of production are used but also when more durable capital goods are employed in production. From a monetary point of view a new monetary stream is present, namely, a monetary demand for durable capital goods from the upper stages.

4.3. Economic growth under invariable money

Let us now imagine that Figure 4 represents a stationary economy (no economic growth). At a certain point of time however the economic agents suddenly decide to consume less. The newly available savings would in the simplest possible case just flow into the banks. Banks in turn, faced with an abundance of money will lower the interest rates and extend more credit to the producers. This newly available money will be used for investment, which in fact means that more capital goods (both fixed and intermediate) and original means of production will be bought than before. If we imagine for the sake of the explanation that before this change the same amount of durable capital goods and consumer goods was produced, i.e. that the division between the two in the lowest stage was exactly in the middle, then after the change the demand for durable capital goods will increase. The latter means that the border between capital and consumer goods will move to the left (see the graph). This will prove possible because companies such as GM will simply start producing more trucks at the expense of consumer autos. The newly-appeared demand for capital goods will be taken into account and the producers will adjust their production. After all it does not matter if the producers’ sales proceeds come from trucks or autos. Now, let us go up the depicted graph. The producers at the next level up will also adjust their production towards more capital goods-geared parts but they will have to adjust less, since some of the parts are not that specific. The same process will happen at the level of flotation and melting plants but to a much lesser extent. And at the level of ore production no adjustment whatsoever will be necessary.

The above discussion has implications for the theory of saving. What we observe in general is that the newly available saving does not affect only the level of consumer goods, it permeates the whole productive structure. If more is saved then more resources in the stages up the chain will be used for the production of durable capital goods. In other words, when we save money we save resources such as steel and iron ore at the same time. We do not save only consumer (present) goods. Because of the complex temporal structure of the economy resources are released and redistributed not only from the last stage but also from the ones up the chain. These newly-available resources in turn will be used for the production of durable capital goods. The economy will become a more capital-goods oriented one. At the same time, since more savings are available the companies at each and every stage will be able to get more original means of production and durable capital goods and thus all stages will grow together. The rate of profit will make sure that the relative amount of investment among the different stages is kept in balance. Because of the synchronizing function of the rate of profit the whole economy will grow together, as a single entity.

We presumed at the beginning that an increase of savings was needed to bring the economy out of the stationary (i.e. no growth) state. However from now on no net saving will be necessary. The available amount of gross saving will be enough to guarantee the future growth of the economy. Thus an increase of the rate of saving is not required. Only an initial “push” of saving was required to bring the economy out of the stationary condition.

It is instructive to discuss in more detail what the specific processes in the economy before and after the initial push have been. In the stationary state of the economy a specific amount of consumer and durable capital goods have been produced. The durable capital goods produced have been just enough to substitute the capital which was worn out, i.e. to compensate the depreciation. Thus no net growth of the capital in the economy was possible. The available saving has been enough to cover just the capital substitution needs of the economy. At a certain point however the economic agents suddenly decide to save more. Let us presume that these are just the final consumers. Thus consumers will buy less cars and will put their surplus money in the banks, invest in stocks, etc. Many car-producing companies at the last stage will have to either go bust or downsize. Workers will be laid off and plants will stop operating. In general: capital and labor resources will be freed. The plants mentioned however have suppliers from the upper stage (car parts producers). Since car parts will not be required as much as before then the car-parts suppliers will also have to go-bust or downsize, thus releasing labor and capital resources too. This process will go up the chain until it reaches the level of the ore-mining companies. At the same time however an opposite process will be present. Banks will lend the newly available savings to producers so that they can expand their production. For instance a new ore-mining operation will be started at the top-most stage. A part of the freed labor force will take part in it. A new operation however needs capital equipment to be built and operated later (trucks, machinery, etc.). Thus an expansion of the truck producing companies at the last stage will be necessary and a part of the newly available savings will go there. Capital and labor will follow. The suppliers of truck parts will also expand their operations in order to match the needs of the truck producers, thus employing more labor, machinery, etc. The same process will happen with their suppliers from the next level up. The overall result will be that resources at all stages which were previously geared towards the production of consumer goods will be moved towards the production of capital goods (fixed and intermediate). As we can see a restructuring of the entire economy is set in motion. As discussed the rate of profit will make sure that the new investment and restructuring will happen synchronously at all stages. And once the savings-push caused restructuring has been completed the economy will continue to grow with the same amount of gross saving. The reason will be that after the restructuring it will produce more capital goods than are necessary to cover the capital substitution needs of the economy.

 

4.4. Economic retrogression under invariable money

Let us now imagine the opposite, namely that the time preference of the consumers changes suddenly and they decide to consume more. Then the opposite process will occur. Resources will be withdrawn from the industries geared toward production of finished capital goods and transferred towards ones producing consumer goods. Thus a company such as GM will decrease its truck production and increase the amount of autos coming out of its plants. GM suppliers will also start producing more  auto parts than truck parts and so on. The economy will switch towards less capitalistic production, i.e. towards producing more consumer goods. And the latter will affect the whole productive structure.

5. Conclusions

It was shown that the Austrian Capital Theory by itself has serious inconsistencies. ACT cannot include fixed capital goods in the process of production in fact, despite claims to the contrary. Thus ACT cannot account for the production of durable capital goods too. ACT presupposes that net saving is necessary in order for economic growth to take place. It was shown however that an economy can grow with no net saving. An alternative economic theory, which corrects the mentioned deficiencies was developed. The processes of economic growth and retrogression were described with its help.

  

References

 De Soto, Jesus (2012), Money, Bank Credit, and Economic Cycles. Auburn, Alabama: Ludwig von Mises Institute.

Garrison, Roger (2002), Time and Money., New York, NY: Routlege

Hayek, Friedrich (1967), Prices and Production. Auburn, Alabama: Ludwig von Mises Institute.

Reisman, George (1990), Capitalism. A Treatise on Economics. Laguna Hills, California: TJS Books.

Repapis, Constantionos (2011), “Hayek’s Business Cycle Theory during the 1930s: A critical Account of Its Development.” History of Political Economy 43:4.

Rothbard, Murray (2009), Man, Economy, and State with Power and Market. Auburn, Alabama: Ludwig von Mises Institute.Skousen, Mark (1990), The Structure of Production., New York, NY: New York University Press