Leithner Letter No. 41
26 May 2003

An erroneous theory of capital, which views existing capital investment exclusively as the material wealth of the economy, is the ultimate reason why vulgar economics – as well as in many cases economic policy – is caught up in ... fetishism.

Richard von Strigl, Capital and Production (1934)

The understanding of the nature of capital and of the economic process in a capital-using market economy ... is based on a consistently-followed approach. This logic sees economic theory as the extensively worked out logic of acts of individual choice ... and when we turn to examine some of the problems which writers on capital theory have encountered, we will almost invariably find that these have arisen out of a failure to view things from the point of view of individual plans.

Israel Kirzner, An Essay on Capital (1966)

Putting Capital Back Into Capitalism

“On the level of policy,” states Prof Roger Garrison in the Austrian Economics Newsletter, “Keynesianism is far from being out of favour, despite [the fact that it is not] on the cutting edge in the mainstream journals. If you keep track of policy matters by reading The Wall Street Journal, you find that the newer, allegedly more rigorous theories have virtually no role to play in driving debate. What drives the thinking of policy makers is 1960s-style Keynesian thinking.”

Whether it is conscious or not, and regardless of their lip service to prudence, virtually all of today’s politicians regard an increase of expenditure as a necessary condition of prosperity (see for example Congress Exceeds Its Credit Limit). Mass media obligingly report and interpret economic and financial developments in a crudely Keynesian fashion. They speak tirelessly of national income, national growth, national labour force and other holistic concepts, and they uncritically disseminate agencies’ latest measurements of these phenomena. Similarly, pollsters’ assiduously gauge “consumer confidence”; prominent market participants obsess about the consumer and government spending they believe drives economic activity, and exhort others to do the same (see, for example, the 9 April 2003 edition of The Australian Financial Review); and all and sundry babble incessantly about “uncertainty.” Accordingly, in this Keynesian world if expenditure rises and particularly if it exceeds expectations then all rejoice; and if it undershoots expectations then they strike glum notes.

Prof Garrison adds that “Keynes ... threw capital theory out of macroeconomics. Keynes himself acknowledges this in his 1937 summing-up article [‘The General Theory of Employment,’ Quarterly Journal of Economics, 51:209-223]. He was proud to have found a way to break macro loose from all the thorny issues of capital theory.” So too “those trained in the Chicago tradition. They all learnt ... that they didn’t have to pay attention to capital and so they ignored it. They have always considered it irrelevant to macroeconomics. ... When [Prof Milton] Friedman launched the counter-revolution against Keynes, one point he never attacked was the throwing of capital out of macro.”

Contemporary mainstream macro-economics is thus labour- and money-based; that is, it focuses upon (and its policy prescriptions tend to adduce a privileged position to) employment and expenditure; and it virtually ignores, and its resultant policies tend to trivialise and even denigrate, capital and investment. (Accordingly, most of the “investment” promoted by politicians is actually thinly-disguised consumption undertaken by politically-favoured groups.) In his oft-quoted remark “we’re all Keynesians now” Prof Friedman meant that an analytical framework based upon employment and consumption underlay both his and Keynes’s economics.

In sharp contrast, capital lies at the core of modern Austrian macroeconomics (see, for example, Roger Garrison, Time and Money: The Macroeconomics of Capital Structure, Routledge, 2001, ISBN: 0415079829; Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, 2000, ISBN: 0415197627; and Peter Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World, Routledge, 1999, ISBN: 0415147069). Given that modern economies are capital-intensive, and that heterogeneous capital goods, subjective entrepreneurial expectations and episodes of boom and bust characterise modern commerce, it makes sense to apply a capital-based macroeconomics to the analysis of these and related matters. It makes particularly good sense in light of the pseudo-scientific and mathematical morass into which modern macro has fallen, as well as its policy failures with respect to unemployment, inflation, growth, productivity and the business cycle (see in particular Henry Hazlitt, The Failure of the New Economics: An Analysis of the Keynesian Fallacies, Foundation for Economic Education, 1959, 1994, ISBN: 1572460024; and William Hutt, The Keynesian Episode: A Reassessment, The Liberty Fund, 1979, ISBN: 0913966606). The assumptions, methods, results and implications of modern Austrian macroeconomics, it seems to me, present fundamental challenges to mainstream theorists and policy makers – and invaluable insights to investors’ allocation of capital.

What Is Capital?

The contemporary mainstream fixates upon short-term consumption, the classical economists focussed upon long-term growth and the Austrians direct their attention to the “real coupling” of the two, i.e., the trade-off between consumption today and possibly greater consumption in the future. This coupling requires capital and its comprehension necessitates a theory of capital. If labour and natural resources are regarded as original means of production, and if consumer goods are the ultimate end towards which production is directed, then capital occupies a position that both logically and temporally intervenes between original means and ultimate ends. A drastically oversimplified example: in order to produce motor cars one requires car parts, labour and machinery; to construct car parts one requires metal, labour and machinery; and to extract iron ore one requires labour and machinery. To comprehend these production processes’ technical aspects one refers to engineering and management science; and to understand their economic characteristics one refers to economic science and capital theory.

Clearly, time – and often considerable time – is required to transform these various means into their final ends. Hence this “goods in progress” conception of capital relies heavily upon time and the concept of time preference. Generally, then, capital is that which enables production – and particularly increased production – to occur. Its origins can be traced to the idea of a fund of purchasing power, owned by “capitalists,” which facilitates indirect methods of production. The capital required to manufacture motor cars includes the machinery used to extract and refine iron ore, transform it into steel and meld the steel into car parts. It also includes the machines that facilitate the assembly of the parts into the finished product, the buildings that house the required labour and machinery and the money required to (re)pay workers and creditors.

This “goods in progress” conception of capital, however, is anything but simple: indeed, it is riven with complexities. Further, time-related concepts such as “roundabout production” have been the subjects of much misunderstanding. The inherent complexity of a capital-intensive process of production across geographic space and through time generates a host of knotty theoretical issues (see Frank Fetter, Capital, Interest and Rent, Sheed, Andrews & McMeel, 1977, ISBN: 0836206843; Israel Kirzner, Essays on Capital and Interest: An Austrian Perspective, Edward Elger, 1996, ISBN: 1858984076; and Richard Strigl, Capital and Production, 1934, 2000, The Ludwig von Mises Institute, ISBN: 0945466315). According to Prof Garrison, “it was precisely these issues that underlay the eagerness of macroeconomists in the 1930s to drop capital theory out of macroeconomics.”

So too did the transition from an agricultural to an industrial and an increasingly service-based economy. These shifts have changed drastically the way that production is undertaken, the way in which economists have thought about production – and therefore the nature of the capital that production presupposes. An agrarian economy, for example, relies heavily upon harvests. Next year’s harvest depends to a significant extent upon how much of this year’s crop is saved in the form of seed. This year’s production can be used in three ways: to feed people; to feed the animals that pull the ploughs; and to use as seed for next year. Hence this year’s harvest, to the extent that it is allocated to the second and third uses, serves as capital; and to allocate too much of this year’s harvest to consumption (i.e., to consume capital) necessitates less consumption next year. Given their agricultural milieu, classical economists’ theory of capital thus relied heavily upon savings and was largely a “subsistence fund” theory of production.

In an industrial context, early neo-classicists such as Carl Menger and Eugen Böhm-Bawerk defined capital as a structure of production that over time and through roundabout methods transforms raw materials and intermediate goods (“goods of higher order”) into consumer goods (“goods of lower order”). Capital goods are heterogeneous but can be classified according to their place in the temporal process of production. Menger emphasised that the element of time and the concept of capital are inseparable. So did their successor, Ludwig von Mises, who quipped that “lack of capital is dearth of time.” Capital is also subjective: that is to say, and as Israel Kirzner has said most emphatically, something is a capital good because it is a component of someone’s plan to produce consumer goods. Because these plans change over time, they both create new capital goods and render useless other items that were once regarded as capital.

Accordingly, something is a capital good not because it possesses certain intrinsic properties but because it is part of someone’s plan to create a consumer good. Once capital goods are conceived as elements of an individual’s plan, it follows that the same good may play different roles in different individuals’ plans. Gene Callahan, in Economics for Real People: An Introduction to the Austrian School (Ludwig von Mises Institute, 2002, ISBN: 0945466358) notes “if I use my car to take a Sunday drive, it is a consumer good for me. To a travelling salesman, using the same make of car for sales calls, the car is a second-order [i.e., capital] good. The same model car, used to ferry plans for the construction of a factory back and forth across town, may be many orders of goods away from a final consumer good. The capital nature of a good is not something in the good itself, but is the role the good plays in the plans of acting man. This is not to say that the physical properties of a good are unimportant to their economic character. If oil didn’t have the right chemical properties to be used as a fuel, it would not have become a part of anyone’s plans, except, perhaps, by mistake. But the determining factor in whether something is a capital good or not is a plan” (see also Ludwig Lachmann, Capital and Its Structure, 1956, 1978, Sheed, Andrew & McMeel, ASIN: 0836207416).

The Consequences of Consuming Capital

A venerable (but by modern standards perplexing) approach, the method of Crusoe Economics, demonstrates that capital and its accumulation is a necessary condition (and, when combined with successful entrepreneurship, a sufficient condition) of the sound creation, maintenance and extension of prosperity. The method considers a hypothetical and solitary individual brought face-to-face with the forces of nature on an isolated, uninhabited and virgin island. Crusoe washes ashore with no more than the clothes on his back. Under these conditions it is axiomatic that production must precede consumption; that satisfaction now is preferable to satisfaction later; that the absence of a subsistence fund of capital permits no more than a very meagre standard of living; that Crusoe’s savings, tacit knowledge and successful entrepreneurship beget capital; and that more (and more productive) capital generates higher living standards.

Now roll the clock forward two generations. Thanks to his labour, assiduous saving and successful risk-taking, the level of capital accumulated on Crusoe’s island – and therefore its standard of living – reaches an “advanced” stage. Let us assume, however, that Crusoe’s son (Crusoe II) does not successfully transmit to Crusoe III the tacit and technical knowledge, values and wisdom learnt from his father and which served both so well. Hence Crusoe III learns only incidentally to produce, constantly to whinge and primarily to consume.

Indeed, let us assume that unlike his father and grandfather, and much to the dismay of his father, Crusoe III is spendthrift, self-indulgent and complaisant. He has neither the ability nor the inclination to maintain the livestock, boat, fields, paddocks, pens, sheds, stores, wells, implements and other capital goods bequeathed to him. He eats and drinks excessively, spends much of the day aimlessly, writes nonsense, paints drivel and on frequent and prolonged visits to neighbouring islands acts boorishly, disturbs the peace and otherwise makes a nuisance of himself. He awaits his inheritance and a life of leisure. Crusoe I, whose last resting place is increasingly unkempt, rolls in his grave.

Upon the death of his father Crusoe III assumes the mantle of the estate. Accordingly, when the boat springs a leak he lacks both the knowledge and the desire to repair it. For the same reason, fewer crops are sown and those that are sown are ineptly harvested; livestock breaks through the fences, is not recaptured and the fences are not mended; many implements break and remain unrepaired; and the pens and stables are a disgrace. In short, because his time horizons are distorted away from saving and entrepreneurial activity and are directed almost exclusively towards consumption, Crusoe III’s stock of capital and his capacity to create new capital inevitably shrink. Even worse, as time passes the rate at which he shrinks his capital accelerates. Over time, in other words, his ability to maintain his accustomed standard of living falls and Crusoe III becomes poorer – not necessarily poorer than his father, but certainly poorer than Crusoe I’s and II’s upward trajectory led him to expect.

Importantly, however, the consequences of Crusoe III’s decline into the decadence of excessive consumption and aimless leisure at the expense of hard work, thrift and sobriety are at first hardly noticeable and seem to cause few problems. Because he is able to draw for a considerable period of time upon the capital stock established by his grandfather and expanded by his father, Crusoe III’s standard of living seems superficially to remain unchanged: indeed, it is likely that for some time he will be able to consume more and more. To the outside observer nothing seems greatly amiss – and to contemporary mainstream economists “growth” continues apace. Below the surface, however, it is clear that (literally as well as figuratively) Crusoe III is consuming his seed-corn.

It takes time for the negative consequences of his values and actions to manifest themselves; eventually, however, they become apparent. Because fewer fish can be caught but the consumption of fish continues or even increases, the store of dried and cured fish depletes. Similarly, because fewer fruits and vegetables are harvested but consumption continues unabated, the store of dried and preserved fruits and vegetables diminishes; and less fresh meat and milk are available and the stock of salted beef and pork shrinks. Crusoe III’s defining economic characteristic, then, is to increase his current income by depleting the present value of his capital. Like an impaired company, he draws upon non-current assets in order to meet current expenses. Born to expect the local equivalent of long lunches, long service leave and perpetual lattés, Crusoe III’s impairment of his capital ensures that he must eventually live on less. The return to the living standards to which he is accustomed – to say nothing of their improvement – requires a much higher rate of savings and level of capital formation than he has hitherto evinced. It will therefore require technical and tacit knowledge, successful entrepreneurship and a significant amount of time.

Crusoe III Is Us?

Given its focus upon employment and consumption and its denigration of capital and investment, contemporary mainstream macroeconomics is blind to developments such as these. Keynesians and Chicagoans tend to treat capital as an homogenous lump. Not only does this lump somehow maintain itself: perhaps with divine (but certainly without entrepreneurial) involvement, it also manages to yield a steady and constant return. Clearly, however, capital goods do not miraculously spawn substitutes and replacements; further, the returns from capital goods are as irregular as the goods themselves are diverse. If they are replaced and extended, as our Victorian forebears did, then higher standards of living eventuate. Alas, the historical record also reveals episodes during which individuals consumed previously-accumulated capital. The result in these instances has been a decline (or deceleration in the rate of increase) of material and moral standards. Imperial Rome provides an ancient example; Argentina is a contemporary one.

Certain aspects of our excursion into Crusoe Economics also correspond roughly to contemporary reality in major Western nations (see in particular Hans-Hermann Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Books, 2002, ISBN: 0765800888). Paul Kasriel, Director of Economic Research at Northern Trust, in an excellent research note dated 27 February 2003 and entitled The Decaying of America noted that “the ‘New Economy’ of the 1990s was less than meets the eye. The capital stock of America is depreciating at its fastest pace in 72 years – faster than at the depth of the Great Depression.” Like Crusoe III, Americans and other Westerners prefer to devour rather than replant their seed corn – and are thereby diverting ever more of their means to unproductive purposes. “Going forward, we will be devoting a larger proportion of our economic resources to national defence, including homeland defence. Unless the rest of the world advances us even relatively more resources than it has, our private capital stock will grow slower. All else the same, our productivity growth will slow.”

During recent decades, most Westerners have resembled Crusoe III at least as much as his father and grandfather. In Australia, for example, households’ average rate of savings has decreased steadily since 1975 and stood at a record -0.5% in December 2002. For the first time – with the possible exception of the Great Depression – Australian households are collectively spending more than they earn. According to The Australian Financial Review (7 March 2003), savings “could remain below zero even when the effects of the drought on farmers’ incomes fade.” In this country, as in America and Britain, consumers’ expenditures are presently bolstered significantly by the consumption of home equity. Yet the candle is burning at both ends: “in a major turnaround during the past two years, Australians have increased the amount of borrowing on their homes at a faster rate than they have been paying it off” (AFR 21 February 2003).

To some extent these developments may have transpired because governments encourage individuals to emulate Crusoe III and to ignore or denigrate his forebears. “Since the end of 2000,” added The AFR, “this ‘net equity withdrawal’ has lifted household disposable incomes by about 3.5 per cent, helping to keep the economy afloat. The [Reserve Bank] said this was also happening in the U.S. and Britain, and was not necessarily bad.” For its part “the Commonwealth government brushed off this development. [The Prime Minister] sought to refocus attention on the benefits to the household sector of low interest rates” (The Australian 7 March).

Bearing in mind the essentially subjectivist characteristics of capital and therefore the inherent difficulty of enumerating it, these developments have cumulatively damaging consequences. According to Kasriel, “for all the hype about the ‘New Economy’ of the 1990s, both growth in the capital-to-labour ratio – so-called capital deepening – and growth in business productivity were clearly sub-par in a post-WWII historical context.” The rate of growth of the capital-to-labour ratio accelerated during the 1990s. This growth, however, was very modest compared to that which preceded it. “Not surprisingly, then, the same can be said for business sector productivity growth.” Chart 3 from Kasriel’s research note, reproduced below, plots the real depreciation of America’s total capital stock as a percentage of real GNP. It has risen almost without interruption since 1965, and in 2001 exceeded 14.3%. The previous record, 12.6%, was set in 1932 – the nadir of the Great Depression.

Chart 3
from Kasriel

From these developments follow four important implications for value investors. First and foremost is the sharp distinction between the soundly-based growth and prosperity created by Crusoes I and II and the artificial and ultimately untenable “growth” indulged by Crusoe III. More generally, is growth something that happens when individuals adopt sound principles and are left to their own devices? Or is it something that policy élites create and bestow upon the benighted? As Prof Garrison puts it, “is the verb ‘to grow,’ as used in economic debate, an intransitive verb or a transitive verb? Capital-based macroeconomics provides us with reasons for associating this fundamentally intransitive verb with sustainable growth and its transitive variant with unsustainable growth. That is, the economy grows, but attempts to grow it can be self-defeating.”

Michael Kelly, the editor-in-charge of The Atlantic Monthly who was killed in Iraq on 3 April, has expressed this point more evocatively. In a commentary entitled Poking the Walrus (The Atlantic Monthly March 2002; see also The Australian Financial Review 14 April 2003) he stated that

I find it hard to take this kind of talk seriously, no matter which leader of which party it comes from. The idea of politicians stimulating the economy conjures up for me an unfortunate picture of small, anxious men (wearing white lab coats and looking like Woody Allen) poking and fiddling (“let’s stick a giant tax cut up here and see what happens”) their way around some very large and somnolent creature (looking sort of like a giant walrus) with results that range from pathetic failure to disastrous success. I always think, “Oh, dear” (well, really it is more like “Oh, good”) that the big thing is just going to roll over on them and they are going to get hurt again.

Secondly, the economic funk that presently plagues America (and Australia and Britain) is not the consequence of the short-term phenomena, such as the wars against Saddam Hussein and Osama bin Laden, about which the contemporary mainstream obsesses. Rather, it is at least partly the consequence of a fundamental and long-term impairment of these countries’ capital-based structure of production. Politicians’ glorification of expenditure and denigration of savings, entrepreneurship and investment have contributed to this impairment; and the tenets of contemporary mainstream macroeconomics have dressed this glorification and denigration in fashionable theoretical garb. If so, then the military conquest of Iraq (which a wag in The Australian has dubbed a “Weapon of Mass Distraction”) will not trigger the restoration of economic blue sky and sunshine. Neither business nor consumer expenditure, in other words, are likely to resume the torrid pace they set during the late 1990s. Like Crusoe III, today’s consumers and businesses undoubtedly wish to recommence debt-financed spending sprees. The weakened state of their stock of capital, however, constrains their ability to do so. The Keynesian mainstream will bewail and denounce this development. But Austrians will welcome it. This is because a diversion of expenditure from consumption and towards savings and investment makes possible the repair of the capital base upon which future prosperity ultimately stems.

Thirdly, and more generally, a sound structure of production requires the sensible investment of additional capital goods – and not more expenditure of money and extension of credit. Today it is apparent that the boom conditions enjoyed in some parts of Australia, Britain and Canada and many parts of the U.S. during the mania of the 1990s were to a significant extent illusory. And to an equal extent – but not as yet equally apparently – Australians, Americans, Britons and Canadians then lived and today continue to live on borrowed time and borrowed money. Crusoe III’s fate tells us that an extended squandering of capital must eventually produce a reckoning. If so, then Westerners in general and Americans in particular will be obliged, perhaps suddenly, to restrict the consumption to which they have become accustomed. Not only will they be forced to confine their consumption to a level compatible with their chastened circumstances and impaired base of capital: their belts must remain tight until that base has been repaired and rebuilt. To do so they must save aggressively, harness tacit and other knowledge and undertake successful entrepreneurial activities.

As a final implication, Kasriel asks “what can one expect in terms of productivity growth if capital spending is tepid? America’s local and state governments, most of whom are forbidden to run deficits, are financially strapped. This is going to severely limit their infrastructure spending. The federal government will continue to increase its spending on military equipment. But because of budget constraints, non-defence federal infrastructure spending will necessarily be constrained. All of this augurs poorly for the economy’s potential growth rate. Thus, the trade-off between real economic growth and inflation is likely to worsen.”

Plus Ça Change: Back to the 1970s

Kasriel’s last point, despite its low-key expression, is explosive. It suggests, notwithstanding the allegedly more enlightened public policy and rigorous economic theory of the past quarter century, that today’s economic trials and tribulations resemble those that were faced – and supposedly resolved – during the 1970s and early 1980s (see also Letter 27 and The Return of Stagflation by Nicolas Bouzou). Alas, it seems that the lessons purportedly learnt during those years have either been forgotten or unlearnt; accordingly, today’s mainstream policy prescriptions (the Reserve Bank’s stance is resolutely “accommodative” and the incumbent Liberal-National government is the highest-taxing and highest-spending in Australian history) are suspiciously similar to those that failed and created additional problems in the 1960s and 1970s.

It is ironic, given politicians’ addiction to ever greater amounts of spending – and left-of-centre politicians’ allegedly most egregious addiction to spending, debt and deficit – that a handful of Labour politicians’ words have not only exploded the bankruptcy of crude Keynesianism: they have also (and surely unwittingly?) embraced a central conclusion of modern Austrian macroeconomics. What James Callaghan told the Labour Party conference in 1976 was true then and is no less true today: “we must ask ourselves unflinchingly, what is the cause of [our economic troubles]? Quite simply and unequivocably, it is caused by paying ourselves more than the value of what we produce. This ... is an absolute fact of life, which no government, be it left or right, can alter. ... We used to think that you could just spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists; and that insofar as it ever did exist, it worked only by injecting bigger doses of inflation into the economy. And each time that happened the average level of unemployment rose. Higher inflation followed by higher unemployment: that is the history of the last 20 years” (see also Roger Douglas, Unfinished Business, Random House of New Zealand, 1993, ASIN: 1869411994; and Peter Walsh, Confessions of a Failed Finance Minister, Random House Australia, 1995, ISBN: 0091830354).

In a very limited and rhetorical sense these sentiments have survived into more recent times. Gordon Brown, for example, told the Labour Party conference in 1997 that “you cannot build the new Jerusalem on a mountain of debt. ... Just as you cannot spend your way out of recession, you cannot, in a global economy, simply spend your way through recovery either.” Alas, Keynes’s personal philosophy (“in the long run we are all dead”) has been adopted far and wide and crude Keynesianism remains as politically orthodox as ever – particularly among “conservatives.” According to the U.S. Treasury’s assistant secretary for financial markets (The Wall Street Journal 19 February), “to quote previous secretary Paul O’Neill, the [U.S. Government’s] debt ceiling is an abomination and must be abolished.” And in Japan, a leading LDP politician has staked his claim for the party’s leadership upon yet another big-spending “recovery” plan. The AFR (14 April) quotes him: “someone has to spend money. Then who? The only one is the government.”

Chris Leithner


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