Prague Conference on Political Economy, Prague, 2018

 

  1. Introduction

An important view of the Austrian school of economics is represented by its theory of capital. The Austrian Business Cycle Theory (ABCT) 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 ABCT to reflect and explain the development of an economy. In particular, it will be argued that:

  1. The ABCT does not 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 ABCT does not account for the fact that an economy produces not only consumer goods but also capital goods.
  3. The ABCT presupposes that the rate of interest must continually go down with the development of the economy. 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.

 

  1. Overview of the traditional ABCT

The ABCT 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 final 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.

According to ABCT the process of economic growth under invariable money happens with the decision of the economic agents to save more than before. The decrease of consumption causes the last stage to shrink in monetary terms and this leads to a subsequent shrinking of the stages up the graph (elongation) along with the creation of new stages over the topmost stage of the graph. Since savings are increased then the rate of interest must go down. The process of economic retrogression happens when and if the economic agents decide to save less and consume more. In this case the last stage of the graph expands at the expense of the above ones and some of the top-most stages disappear. Since savings are decreased then the rate of interest must go up.

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 ABCT

 3.1. The inadequacy of ABCT to represent fixed (durable) capital goods

When we inspect the given ABCT graph we cannot avoid noticing that all the goods represented are intermediate (circulating) capital goods. The so called fixed (durable) capital goods are not present anywhere on it. As an example we can map the production of bread to the standard ABCT graph. Land itself (an original means of production) is used to grow grain. Thus land and human labor enter the top-most stage of production and what exits is grain. What is not shown however is the amount of machinery ( tractors, etc.) employed in grain production. Grain passes to the second stage where it is being ground and flour exits from it (in downwards direction). Again, what is not shown is the tools/machinery used, in particular the grinding mills. In such a way we proceed downwards to the lowest stage where the already baked bread is sold to the consumer. Still, no stage depicts the fixed capital goods, which represent the main bulk of an economy. If we traverse the graph in the opposite direction we see money being exchanged for intermediate goods only. No money is used for fixed capital goods and it can not be used in fact, because the fixed capital goods (i.e. plants, machinery, tools) are finished products which belong to the producers in the depicted stages of production. Once a fixed capital good is bought it is being used in production and not exchanged for money any more.

Fixed capital goods require expenses for depreciation allowances and this money must be paid from the sales proceeds at every particular stage. It is not clear if the latter has been taken into account by ABCT at all and if yes then how. But even if it was taken into account (for instance as a part of the interest), this money is only a small part of the value of the fixed capital goods as such. A plant which offers useful services in the time span of 10 years depreciates approximately by 1/10th of its value in a year. The ABCT does not include the rest 9/10ths of the capital (and most likely the first 1/10th also). The simple reason is that the ABCT is a flow diagram. In other words in depicts only monetary transactions and their outcomes. The fixed capital however is not exchanged when used in production and thus is not representable on it. From another point of view the ABCT graph shows only the distribution of the amount of money present in an economy. The 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 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. Thus ABCT excludes from discussion an enormous amount of economic capital present in each and every economy.

Fixed capital goods generate interest income for their owners as well. The above is once more not taken into account by the standard ABCT graph, since it presumes that all income at a particular stage resolves into original means of production (land and labor), intermediate goods from the prior stage and specific interest accruing to the capitalists on the same stage. For example Rothbard denies explicitly that capital as such (i.e. fixed capital also) generates income, quote: ”As we have seen and shall see further below, capital goods are not independently productive. They are imputable creatures of land and labor (and time). Therefore, capital goods generate no interest income. We have seen above, in keeping with this analysis, that no income accrues to the owners of capital goods as such” (Rothbard 2009, pp.352). Later Rothbard contradicts himself by saying, quote: “Since all goods have unit services, all goods will earn rents, whether they be consumers’ goods or any type of producers’ goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them. As a result, the investors and producers of these goods tend to earn simply an interest return on their investment.” (Rothbard 2009, pp.558). In fact, as can be seen throughout the mentioned book Rothbard implicitly excludes the fixed capital goods from his discussion of ABCT, although he explicitly claims the opposite, i.e. (Rothbard 2009, pp.401), quote: “ … but suffice it to say, that there is no great difference between durable and less durable capital. Both are consumed in the course of the the production process and both must be paid for out of the gross income and gross savings of lower-order capitalists.” The same attempt to include the fixed capital goods in ABCT is present in De Soto (2012, pp.299), quote: ”From a human actor’s perspective point of view, the distinction between fixed and circulating capital good is irrelevant, since……. both fixed and circulating capital goods constitute intermediate stages in an action process which only concludes when the final consumer good satisfies the desires of of consumers.”

Both mentioned attempts to make fixed capital goods the same as the intermediate capital goods do not hold. The simple reason is that  the prices of the fixed (produced) capital goods are not imputable to land, labor and interest at all. This may be the case with the intermediate capital goods but is definitely not valid for the goods out of production. Their prices are determined by supply and demand only. An example is a painting of Picasso or Leonardo da Vinchi. The prices at which they are sold at present have noting to do with the amount of money spent on paint, canvas, etc. and with the amount of labor to complete the particular work of art. The latter is recognized by Rothbard in his discussion on how the cost of production does not determine prices (Rothbard 2009, pp.356). Still both authors pretend that the latter does not apply to the fixed capital goods and therefore that they can be included in the ABCT (i.e. that they can be resolved into land, labor and interest). Interestingly enough both De Soto and Rothbard in their discussion on “the average period of production “ (De Soto 2012, pp.298) admit that old prices (which include land and labor prices) and the length of time used in the production of final capital goods do not matter at all for the entrepreneur. But if the latter is valid then we cannot logically claim that the already completed capital goods used in production are resolvable into original means of production and interest.

To summarize the above: In a developed economy the amount of fixed capital goods (plants, machinery, etc.) measured in money dwarfs the amount of intermediate goods. Still, these goods are not included by ABCT and cannot be included in fact since they are not exchanged for money when they are used in production. Thus we conclude that most of the capital present in an economy, in particular the fixed capital, is not taken into consideration at all by the ABCT. However, a theory which excludes the main part of the capital in an economy cannot be relied upon. Thus we must conclude that ABCT is inadequate for general economy description purposes.

 

3.2. The inadequacy of ABCT to account for the production of final/finished 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 final/durable capital goods as well and they must somehow be included in the productive structure, since they are an inseparable part of it. Following the pertinent criticism of Reisman (1990, pp.709) we cannot simply pretend that they are somehow miraculously created out of the available savings and accrue to the different productive stages from the side, as investment. ABCT does not in fact discuss how the final  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”. The reader is asked to remember the above-mentioned quote, since it will be re-used again in another context in the next section. What is missing here is (4) the very well known fact that entrepreneurs use savings to buy finished (final) 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 ABCT 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 final 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 final/finished capital goods are being produced and this must somehow be accounted for. And second we cannot simply single out the final consumer goods and pretend that they are the only product of an economy. The simple reason is that we can not distinguish which part of the original resources (e.g. iron ore) goes towards each of the two types of production (consumer and final capital goods). In the higher order stages the production is non-specific, which means  that it is not distinguishable/separable. Thus by presuming that only consumers goods are produced we exclude from the discussion an immense amount of durable and intermediate capital present in an economy and moreover we separate inseparable production lines.

To summarize all of the above: We cannot simply separate the production of consumer and final capital goods. Both are products of the same structure. But if the latter observation holds then the structure of ABCT must account for this fact, what is not the case however. The only product of ABCT is consumer goods, what in fact contradicts reality and that is why it must be put into question and qualified as objectionable.

 

3.3.  The inadequacy of the presumption underlying ABCT that a decrease of the rate of interest is a necessary condition for an economic growth

 According to the standard descriptions of ABCT, in order for the productive structure (as depicted in Figure 1) to grow an increase of saving is necessary. In other words if and only if the economic agents decide to save more can economic growth occur. An increase of gross saving however entails a decrease of the general, economy-wide rate of interest. Thus ABCT presupposes that economic growth can happen only and only if the rate of interest goes down. The latter claim leads to some interesting consequences when projected into the far future. What it means is that more and more saving will be necessary, and thus in the distant future almost all income will have to be saved and the interest rate will approach zero. Only with the latter would it be possible to guarantee the existence of continuous economic growth. George Reisman disagrees in (Reisman 1990, ch.15) and develops a way in which an economy does not constantly need lower interest rates in order to grow. We will discuss the problems embodied in the original ABCT first and later represent Reisman’s idea in our own way.

A justification of why an increase of saving is necessary can be found in De Soto (2012, pp.280):” Depreciation refers to the wear capital goods undergo during the production process. A certain minimum level of saving is essential in order to compensate for depreciation by producing the capital goods necessary to replace ones that have worn out or depreciated. This is the only way for the actor to maintain his productive capacity intact. Moreover if he wishes to further increase the number of stages, lengthen the processes and make them more productive, he will have to accumulate even more than the minimum savings required to counteract the strict amortization rate, the accounting term for the depreciation of capital goods.”

The logic behind the last statement is based on the view that savings are used to buy new capital in the form of original means of production and intermediate products from prior productive stages (see the quote at the beginning of the previous section). But this new capital capital is supposed to depreciate as well and we have to cover its depreciation by additional savings. The problems with the above view are two. First, as already discussed, ABCT views capital as exclusively composed of original means of production and intermediate capital goods. However this type of capital does not depreciate at all. Only the fixed capital goods employed in production (plants, machinery, etc.) depreciate but they are not included into the discussion. Thus we must conclude that the above claim is not valid in the presumed context. Second, if we correct the above implicit context  and include somehow the fixed capital goods into the discussion (since they are the ones that depreciate) we still have a problem. And this is once more the presumption that all capital needs support in the form of savings. Here comes the contribution of George Reisman in (Reisman 1990), who 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 final capital goods as well, but the final 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 capital (original means of production, fixed, intermediate and final capital goods together) of a monetary value C. Let us presume for simplicity an amortization rate of 10% per year and that the depreciation happens not continuously throughout the year but only once at the end. 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 final durable capital goods too. Let us presume that until the end of the year the original capital C has been able to produce an amount of 0.1*C final 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 final 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 final 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 final 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 final capital goods per year. The latter can be accomplished if we devote enough resources for production of final 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 if a particular level of 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 the 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:  A decrease of the rate of interest is not a precondition for economic growth to occur. 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.

 

4. An alternative capital structure theory

 4.1. Basic structure

 When taking into consideration and correcting the issues with ABCT 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 ABCT 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 final 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 final 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 ABCT growth happens not only when more original means of production are used but also when more final/finished capital goods are employed in production. From a monetary point of view a new monetary stream is present, namely, a monetary demand for final 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 final 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 final 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 intermediate 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 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 final 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 final capital goods have been produced. The durable/final 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 (final 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 Business Cycle Theory by itself has serious inconsistencies. ABCT does not consider the inclusion of fixed capital goods in the process of production in fact, despite claims to the contrary. ABCT does not account for the production of final (durable) capital goods but they cannot be simply separated from the overall production process. ABCT presupposes that the rate of interest must go down 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.

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.

Rothbard, Murray (2009), Man, Economy, and State with Power and Market. Auburn, Alabama: Ludwig von Mises Institute.