With the resurgence of Keynesian
economic policy as a response to the current crisis, echoes of past
debates are being heard - in particular,
the debate from the 1930’s between John Maynard Keynes and Friederich Hayek. Keynes
talked about the “capital stock” of the economy. He argued that by stimulating
spending on outputs (consumption goods and services) one can increase
productive investment (adding to the capital stock) to meet that spending, thus
adding to the capital stock and increasing employment. Hayek accused Keynes of
insufficient attention to the nature of capital in production. (By “capital” is
meant here the physical production structure of the economy, including things
like machinery, buildings, raw materials, and, we should also include, human
capital). Hayek pointed out that capital investment does not simply add to
production in a general way, but, rather, is embodied in concrete capital
items. The productive capital of the economy is not simply an amorphous “stock”
of generalized production power; rather it is a very intricate production
structure of interrelated complementary specific production items. Stimulating
spending and investment amounts to stimulating specific sections and components
of this intricate structure. The “shape” of production gets changed by
stimulatory activist spending. And,
given that productive resources are not free, this change comes at the expense
of productive effort elsewhere. The pattern of production gets out of sync with
the pattern of consumption and eventually this must lead to a collapse.
Productive sectors, like dot.com start-ups or residential housing, become
“overbought” (while other sectors develop less) and eventually a “correction”
must occur. Add this “distortionary” effect to the fact that the original
stimulus must somehow eventually be paid for and we have a predictable bust.
These Hayekian criticisms are
once again relevant. It is necessary therefore to return to the nature of
capital in order to, once again, clarify the issues. Hayek was working from
foundations that were developed by his intellectual forebears in the Austrian
School of Economics. Specifically, it is the Austrian Theory of Capital that is
relevant and we should begin with that.
The best known Austrian capital
theorist was Eugene von Böhm-Bawerk, though his teacher Carl Menger is the one who
got the ball rolling, providing the central idea upon which Böhm-Bawerk
elaborated. Böhm-Bawerk produced three volumes dedicated to the study of
capital and interest, making the Austrian Theory of Capital its most well-known
theoretical contribution. He provided a very detailed account of the
fundamentals of capitalistic production. Later contributors include Hayek,
Ludwig Lachmann and Israel Kirzner. They added to and enriched Böhm-Bawerk’s
account in crucial ways. The legacy we now have is a rich tapestry that accords
amazingly well with the nature of production in the digital-information-age. Some
current contributors along these lines include Peter Klein, Nicolai Foss, Howard
Baetjer, Peter Lewin and others.
The Austrians emphasize the fact
that production takes time, and the more indirect it is, the more “time” it
takes. Production today is much more “roundabout” (Böhm-Bawerk’s term) than
older more rudimentary production processes. Rather than picking the fruit in
our back yard and eating it, most of us today get our fruit from fruit farms
using complex picking, sorting, packing machinery to process carefully
engineered fruit items. Consider the amount of “time” (for example in
“people-hours”) involved in setting up and assembling all the pieces of this
complex production process from scratch – from before the manufacture of the
machines, etc. – and this gives us some idea of what is meant by production
methods that are “roundabout.”
[The scare quotes above are
used because, in fact, there is no perfectly rigorous way define the length of
a production process in purely physical terms. But, intuitively, what is being
asserted is that doing things in a more complicated, specialized way is more
difficult – loosely speaking it takes more “time” because it is more
“roundabout,” more indirect.]
Through countless self-interested
individual production decisions, we have adopted more roundabout methods of
production, because they are more productive – they add more value - than less
roundabout methods. Were this not the case, they would not be deemed worth the
sacrifice and effort of the “time” involved– and would be abandoned in favor of
more direct production methods. What is at work here are the benefits of
specialization – the division of labor to which Adam Smith referred. Modern
economies are complex, specialized economies in which the many specialized
steps necessary to produce any product are connected in a sequentially specific
network – some things have to be done before others. There is a time-structure
to the capital-structure.
This intricate time-structure is
partially organized, partially spontaneous (organic). Every production process
is the result of some multi-period production plan. Entrepreneurs envision the
possibility of providing (new, improved, cheaper) products to consumers whose
expenditure on them will be more than sufficient to cover the cost of producing
them. In pursuit of this vision the entrepreneur plans to assemble the
necessary capital items in a synergistic combination. These capital-combinations
are structurally composed modules that are the ingredients of the industry- or
economy-wide capital-structure. The latter is the result then of the dynamic
interaction of multiple entrepreneurial plans in the marketplace – it is what
constitutes the market process. Some plans will prove more successful than
others, some will have to be modified to some degree, some will fail. What
emerges is a structure that is not planned by anyone in its totality, but is
the result of many individual actions in the pursuit of profit – it is an
unplanned structure that has a logic, a coherence, to it. It was not designed,
and it could not have been designed, by any human mind or committee of minds.
Thinking that it is possible to design such a structure or even to micro-manage
it with macro-economic policy is a fatal conceit.
The division of labor reflected
by the capital-structure is based on a division
of knowledge. Within and across firms specialized tasks are accomplished by
those who know best how to accomplish them. Such localized, often unconscious,
knowledge could not be communicated to or collected by centralized
decision-makers. The market process is responsible not only for discovering who
should do what and how, but also how to organize it so that those best able to
make decisions are motivated to do so. In other words, incentives and knowledge
considerations tend to get balanced spontaneously in a way that could not be
planned on a grand scale. The boundaries of firms expand and contract and new
forms of organization evolve. This too is part of the capital-structure broadly
understood.
In addition, the heterogeneous
capital goods that make-up the cellular capital-combinations also reflect the
division of knowledge. Capital goods (like specialized machines) are employed
because they “know” how to do certain important things; they embody the
knowledge of their designers about how to perform the tasks for which they were
designed. The entire production-structure is thus based on an incredibly
intricate extended division of knowledge, such knowledge being spread across
its multiple physical and human capital components. Modern production
management is more than ever knowledge management, whether involving human
beings or machines – the key difference being that the latter can be owned and
require no incentives to motivate their production, while the former depend on
“relationships” but possess initiative and judgment, in a way that machines do
not.
The foregoing provides the barest
account of the rich legacy of Austrian capital theory, but should be sufficient
to communicate the essential differences in the way Austrians view the economy,
compared to those using perspectives from other schools of thought. For
Austrians the whole macro-economic approach is problematic, involving, as it
does, the use of gross aggregrates as targets for policy manipulation –
aggregates like the economy’s “capital stock.” For Austrians there is no
“capital stock.” Any attempt to aggregate the multitude of diverse capital
items involved in production into a single aggregate number is bound to result
in a meaningless outcome – a number devoid of significance. Similarly the total
of investment spending does not reflect in any accurate way the addition to
value that can be produced by this “capital stock.” The value of capital goods and of capital
combinations or of the businesses in which they are employed, are determined
only as the market process unfolds over time. They are based on the
expectations of the entrepreneurs who hire them, and these expectations
are diverse and often inconsistent. Not
all of them will prove correct – indeed most will be, at least to some degree,
proven false. Basing macro-economic policy on an aggregate of values for assembled
capital items as recorded or estimated at one point of time, would seem to be a
fool’s errand. What do the policy-makers know that the entrepreneurs involved
in the micro aspects of production do not?
The folly is compounded by
connecting capital and investment aggregates to total employment, under the
assumption that stimulating the former will stimulate the latter. Such an
assumption ignores the heterogeneity and structural nature of both capital and
labor (human-capital). Simply boosting expenditure on any kind of production
will not guarantee adding to the employment of people without jobs. How else to
explain the fact that our current economy is characterized by both sizeable
unemployment numbers and job-vacancies? Their coexistence is a result of a structural
mismatch – the structure, the pattern of skills, of the unemployed does not
match those required to be able to work with the specific capital items that
are currently unemployed.
In fact, the current enduring
recession is basically structural in nature. It is the bust of a credit-induced
boom-bust cycle, augmented by far-reaching production distorting regulation.
The Austrian Theory of the Business Cycle was developed first by Ludwig von
Mises, combining insights from the Austrian Theory of Capital with the nature
of modern central-bank led monetary policy. The theory was later used, with
some differences, by Hayek in his debates with Keynes. And over the years its
popularity and acceptance has waxed and waned. But it appears to be highly
relevant to our current situation.
The dot-com boom no doubt
reflected the advent of a pervasive new technological environment – the arrival
and expansion of the digital age. It was a time of great promise and
uncertainty and of enhanced risk-taking. Astronomical book values reflected
expectations that in total could not be realized. A shake-up was inevitable –
and known to be so. It was part of the market process. As the boom deepened
interest rates started to rise, reflecting the increased demand for a limited supply
of loanable funds. This, as Hayek would have put it, is the natural brake of
the economy, the signal and the incentive to slow down. But the Federal
Reserve, not wishing to spoil the party, expanded reserves in order to keep
interest rates low, thus allowing the boom to progress beyond its “natural”
life. When the bust came it was bigger than it would have been had the cycle
been allowed to run its natural course.
Notice how this story accords
with our understanding of the capital-structure. The expanding boom reflected
entrepreneurs’ expectations of profitably making new capital combinations, only
some of which would, in the event, prove to be profitable. But there was no
way, ahead of time, to know which they were. That is why we need markets. Rising
interest rates, and the passage of time, would tend to reveal the less viable
ventures and weed them out. Keeping interest rates artificially low prevented
this from happening, moreso for those projects that were more
interest-sensitive, namely, those that were longer-lived, that had a longer
time-horizon – or, loosely speaking, in terms of our earlier discussion,
contained more “time.”
But the dot-com collapse did not
really mark the end of the cycle. Much of the extra liquidity was then directed
into real estate, specifically into residential housing and into financial
assets based on it. This investment channel was wide open as a result of a
decades long, recently intensifying, Congressional and regulatory policy to
expand home-ownership in America. This is a familiar story that need not be
repeated here. The result was an unprecedented expansion of home-building and
home purchases riding up the tsunami wave of home prices. Once again the
production structure was pushed out of sync with any kind of sustainable
pattern of consumption.
The solution, from this
perspective, is to remove the distortions – to allow the market process to
“re-structure” production. This would mean a sustained period of consolidation
in the housing market, not a policy that attempts to revive it (to revive the
bubble?) of the kind we are currently witnessing. But then, today’s
policy-makers do not have the benefit of knowing Austrian Capital Theory to
guide them.
