One of the main differences between the Austrian school of economic thought and the rest of the economic schools is the Austrian view how the economic growth (i.e. capital accumulation) takes place. This view is embodied in the so called Austrian Business Cycle (ABC) theory. This theory presents a view of how the capital is organized, how it grows, stagnates or diminishes and finally used to explain the boom-bust fluctuations through which economies typically pass, i.e. the so-called economic cycle.
The intent of the present article is to show why the ABC theory is conceptually flawed and therefore must not be used for economic reasoning. In the following discussion I will basically restate George Reisman’s view [1] on how economic progress happens and relate it to the standard ABC theory. Thus I will join the pertinent criticism of other authors, such as Bryan Caplan [2], although  from a different point of view.

A typical view of how the capital in an economy is organized in terms of time, quantity, specificity, etc. can be found in Hayek [3]. The figure I use is taken from there.
According to the the above given view the capital is structured in time, i.e. different parts of it are used for different purposes at particular times. As an example the process of car production starts with iron ore mining, i.e. part of the capital is used for mining iron ore. This capital is shown as the upper most bar in the figure. Once the ore has been mined iron must be produced from it (the next bar downwards), a process which takes another part of the overall capital in the economy and which follows in time the iron ore mining process. Later the produced pure iron is being shaped in suitable car parts  (the next bar down) and at last a whole car is being assembled (one bar down). Then cars are being sold directly to the consumers (the lowest bar in the figure). In Austrian economics terms the processes near the ore mining are called “higher order processes” and the ones near the consumer level – “lower order processes”. Since the last process in the sequence is the sale to the final consumer it is the lowest level (level 0) process. Each bar in the graph represents the monetary value of the particular capital at each stage. When passing from one stage to the next from top down additional work is done and consequently more original means of production (land and labor) are being added on top of the previous stage. That is why bars become wider, i.e. each successive stage embodies a larger amount of invested land and labor than the previous one and consequently its monetary value grows.

Several observations are in order. 1.) As can be observed all that the economy produces is consumer goods, since this is the only output shown. Stage 4 produces goods which are being sold to the consumers in the last (5th) stage. 2.) The process of investment is not shown on the graph. According to the standard explanation it accrues to the separate stages from the side, so to say. I.e. when saved funds are available they are being converted into capital goods somehow and added to the bars in the graph so that bars become wider. 3.) According to the standard explanation, for an economy to grow more saving is necessary, since this is the only way to increase the amount of capital used. As a consequence, for an economy to grow an increase of the general level of saving is necessary, which by extension means that the economy-wide interest rates must constantly fall in a growing economy.

I intend to show that the above given points (from 1 to 3) do not conform to the objective reality. In the following discussion I will reuse part of George Reisman’s arguments as given in [1] .

Let us discuss points one and two first. Suppose that we have an economic process which follows the pattern described above, i.e. iron ore is being mined (Stage 1), iron is being produced (Stage 2) and specific vehicle parts are being molded (Stage 3). These parts are being supplied to a company such as General Motors (GM) which produces two types of vehicles: trucks and autos (Stage 4). We presume that the autos are being sold to the final consumer, i.e. that they represent a pure consumer good. How about the trucks? According to all meaningful definitions they must be classified as a capital good. So, what we have is a company which produces two types of goods, capital and consumer ones. What we can’t fail to notice however is that the stages of iron ore mining and iron production are common to both types of products (trucks and autos). Only in the subsequent stages can we differentiate both types of production. What we also notice is that the vehicle production company uses the same (or very similar) machines and skills to produce both types of vehicles (trucks and autos). In fact it is quite possible that some of the parts in both products are even the same. Because of the above mentioned reasons we are forced to put these company’s products on the same level of production in the graph above, i.e. on level 4.
Autos are being produced and they are being sold to the consumers in level 5 (distribution). How about the trucks however? Since they do not represent a consumer good they are being sold to businesses (as we well know). What this however means is that level 4 of the graph produces output which is not accounted for in the graph itself. The reason is that the graph (as given it the standard ABC texts) shows only an output of consumer goods but trucks are not a consumer good. Moreover the standard ABC graph states that the monetary flows can go in two directions only: first, from consumers to the levels above (passing from a lower level to an upper level one in exchange for produced intermediate goods) and second, sideways (as investment) from the saved funds to every (or some) of the capital goods stages. However in the above described we are being confronted with a process in which money flows from the upper level stages to the stage 4. In particular, when an ore-mining company situated on level 1 buys a truck to carry its ore from our company on level 4. So what we have is a new monetary stream, which is not accounted for in the standard ABC graph.

In addition to the above arguments, it could happen that GM exports its trucks to another country (Kongo for instance). So, if we presume that the standard ABC graph represents the structure of a particular economy (of the USA for instance) or of a group of economies (the whole North American continent for instance) then part of the (unaccounted) output (trucks) leaves the graph itself and never comes back. We are forced to presume that the ABC graph can not be used for the whole Earth for the simple reason that the Austrian economics scholars use it to show how the economic cycle is created. However, as we very well know, the economic cycle is not synchronous, i.e. different countries may be at different stages of the cycle at the same time. It is possible for China to be in a boom stage while the USA is in a bust stage and vice-versa. In order to cope with the above given inconsistency we must re-classify trucks from a capital good to a consumer good, but unfortunately nobody has suggested such a solution. Only in the mentioned way would this particular product (trucks) follow the logic embodied in the ABC graph.

What I wanted to show with the help of the above discussion is that an economy produces not only consumer goods but capital goods too. This however is not shown or accounted for in any way by the ABC theory. It presupposes that all that is produced is consumer goods. The ABC theory assumes that the capital goods come into existence by the separate and allegedly independent process of saving and investment. In reality an independent demand for capital goods exists. In particular if the level of saving in an economy increases, then this would mean a decreased demand for autos and an increased demand for trucks. Thus a company such as GM would simply enlarge its trucks business at the expense of its consumer autos business. GM would switch from a mainly consumer oriented company to a capital goods producing one. For GM it would not matter if the proceeds from its sales come from trucks or from autos.

Once we have dealt with the above problems we are ready to discuss the third ABC theory related problem, i.e. that an increase of saving on the part of the consumers is necessary so that an economy can grow. Again, a recourse to the objective reality will be employed to present the problem. A suitable example, taken from [1] will be used.

A particular economy has had up to a particular point of time a multitude of small steel mills. It has not been able to save enough capital so that a bigger, more efficient steel mill be produced. At a certain point however consumers suddenly decide to save more and the economy produces this bigger and better mill. Now the question which must be stated is: Do we need to save the same or bigger amount of money again if we wish to produce another plant like this? The answer is of course no, we do not. And the reason is that the larger steel mill, which we have already produced will be used to help us produce the second one. The reason why we have produced the particular steel mill in the first place is to be able to produce cheaper and/or higher-quality or bigger size steel products. Basically by using the new plant we are able to put less labor and/or steel into the same product. In short: with the new steal mill we could use our resources more efficiently. But if this is so, then we need less resources than before (labor, steel) in order to produce the second big steel mill. What this however means is that we need less savings to be available for the building of the second one. The conclusion is that we do not need an increase of saving so that the second steel mill be build. The same level of saving which has been prevalent at the time when the first steel plant has been produced will be sufficient for the production of the second one. But if we generalize the above on a macroeconomic level we could conclude the following: an increase of saving is not necessary for an economy to be able to grow. And the reason for the above is that an economy produces capital goods in addition to consumer goods. If we are able to produce consumer goods more efficiently than before (with less labor for instance) then we must be able to produce capital goods just as easily (again with less labor). The latter point has been entirely neglected by the ABC theory. An increase of saving (and a consequent fall of the interest rate) however is a prerequisite for the ABC theory to be valid. As I showed this is not a necessary condition for an economy to grow. If an economy raises its level of saving this would only lead to an increase of the speed of capital accumulation. In Reisman’s words, the increase of the level of saving relates to growth in the same way as force to acceleration.
In order to refine the above a clarification is needed. Every economy has a particular quantity of capital and this capital gets used little by little (depreciation). A part of the output of the economy must be used just for the purpose of maintaining/replenishing the existing stock of capital. But once enough savings have been allocated for this purpose the economy could grow without an additional increase of the general level of saving. The latter contradicts the ABC theory.

In conclusion, with the above I showed that the ABC theory suffers from significant inconsistencies, in particular that it does not account for the production of capital goods, that the process of saving and investment is not a separate and distinct way of capital goods production and that no additional saving is necessary for an economy to grow. The above discussed points put the ability of the ABC theory to explain and in general to conform to the objective reality in question. It must be noted that I have dealt with the easier task, i.e. just to show that a particular theory is inconsistent. I have not offered a competitive theory, which is much harder to do. Still, the latter fact does no render my criticism irrelevant. The knowledge that some theory is wrong or incomplete is knowledge nevertheless.

References

1.“Capitalism. A Treatise on Economics”, George Reisman
2.“Why I Am Not an Austrian Economist”, Bryan Caplan
3.“Prices and Production”, Friedrich A. Hayek