18 Mar 2014

The Continuing Importance of Capital Theory

Austrian School, Capital & Interest, Chicago School, Scott Sumner, Shameless Self-Promotion 24 Comments

My new post at Mises Canada, which on Facebook I summarize as “Friedrich Hayek >> Scott Sumner.” An excerpt:

Now if Sumner’s explanation were the main thing going on, there would be two immediate implications: (1) Booms are good things. And (2) Booms should naturally slide back into normal growth as wages and prices adjust; there is no reason we should ever see a massive slump following a boom. Austrian economists sometimes chide their Keynesian foes for wanting “a perpetual boom,” but here Sumner is explicitly endorsing such a position too (whether or not he realizes it).

In the Austrian approach, on the other hand, there is no mystery here. The layperson’s intuition is right: A boom feels good because it really is a period with an above-normal standard of living, but it is genuinely unsustainable and it is bad. People come to realize at some point that the boom is illusory, and this realization leads not just to a return to normalcy, but a slump. How can we explain these facts? Because during the boom period,people unwittingly consume capital.

If a businessperson who owned a fleet of trucks suddenly stopped spending money on oil changes and didn’t get new brakes even for the vehicles that “needed” them, these decisions would boost (apparent) profitability in the short run. Not only would monetary expenses be reduced, but revenue would be higher, since the entire fleet could be out delivering cargo, rather than having some of the vehicles (at any given time) tied up in maintenance. Yet obviously this temporary boost in profitability would be a sham, with a disaster looming on the horizon.

24 Responses to “The Continuing Importance of Capital Theory”

  1. andrew' says:

    I’ve summarized it as money illusion? Do you really mean it?

    Why can it only work on the downside?

    Your original motor boat story is a classic.

  2. Transformer says:

    “Booms should naturally slide back into normal growth as wages and prices adjust; there is no reason we should ever see a massive slump following a boom”

    Isn’t the whole point of Sumner’s model that indeed there is no reason we should ever see a massive slump following a boom if the monetary authorities are doing their job properly ? Of course the boom itself could and should be avoided too.

    There seems to be plenty of evidence that insufficient AD has persisted in the current slump. Where is the evidence that we used up too much capital during the boom and that is the reason that the recovery has been so slow ?

    Also even if capital was destroyed during the boom – why would that lead to a slump? I can see that overall productive capacity would be reduced and this would lead to a “slump” in actual stuff produced but wouldn’t that result in healthy growth during the recovery as that destroyed capital is replaced ?

    • guest says:


      Where is the evidence that we used up too much capital during the boom and that is the reason that the recovery has been so slow ?

      The artificially low interest rates that cause the boom mislead people into long term investments that they shouldn’t be making.

      The money is being used to transform materials and allocate labor into areas that are not justified by consumer demand. This is how capital is wasted (even when the raw materials aren’t destroyed, since it still takes time and labor to repurpose them).

      Low interest rates affect capital sectors more because they are more time-sensitive. This is why economic crashes hit the capital sector the hardest – not because entrepreneurs overinvested.


      I can see that overall productive capacity would be reduced and this would lead to a “slump” in actual stuff produced but wouldn’t that result in healthy growth during the recovery as that destroyed capital is replaced ?

      The slump happens in those sectors where resources were malinvested and have to be repurposed in order to be profitably invested. This means layoffs and business failures.

      It WOULD result in a healthy growth if the government stayed out of the way:

      Why You’ve Never Heard of the Great Depression of 1920 | Thomas E. Woods, Jr.
      http://www.youtube.com/watch?v=czcUmnsprQI

      But instead they try to “save the free market from itself” with price controls (Minimum Wages; destroying crops to artificially raise their prices) and bailouts (preventing the malinvested resources from being reallocated according to consumer preferences).

    • Andrew' says:

      Transformer (and Bob, feel free to correct me)

      By way of analogy: when Keynesians say that prices don’t adjust in a depression, the classical economists as “well, why not?”

      And Keynesians come with the explanatory of “sticky prices/wages.”

      That is to say, Keynesianism does not NECESSARILY rely on sticky prices. That is just one possible explanation as to how the implicit mathematical model works as to why the economy does not adjust to a new lower priced equilibrium. It just so happens, a lot of Keynesians do seem to hitch their pony to sticky wages. I find that a bit puzzling, but it’s their life.

      In a similar fashion, capital consumption is a way that makes the Austrian model work out in a way that satisfies the critique that there can be no such thing as a boom because people can’t work harder than full employment. It may even be THE explanation, but the important part is that it is AN explanation. I think that human beings can in fact stretch themselves for a short time. Investors can stretch for yield. We can bid up raw material prices, etc. AND we can stretch our equipment and capital beyond their steady-state red line.

      Feel free to correct me Bob. I think I learned it from you in the first place.

      • Andrew' says:

        Have you ever watched the mile (or whatever) in the Olympics? Do you see what happens in the last 50 yards and then what happens just past the finish line?

        Why we assume this can’t just happen in a thing (the economy) with trillions of more moving parts is odd to me. But then that’s almost a critique of Austrian theory, so I’ll quit there.

      • Tel says:

        My understanding of the Austrian theory is that every worker balances the disutility of working against the real rewards of doing that work. They could work harder, but don’t really want to because doing so would make them (subjectively) worse off.

        The term “full employment” is politically loaded and largely meaningless. The definition changes whenever new justification is needed for government spending.

  3. Major_Freedom says:

    Transformer:

    “There seems to be plenty of evidence that insufficient AD has persisted in the current slump.”

    What is the evidence of insufficient money printing, and how can you distinguish that from evidence of an insufficient free market money?

    “Where is the evidence that we used up too much capital during the boom and that is the reason that the recovery has been so slow ?

    Wrong question. We’re all looking at the same evidence. History is unique. There is only one set of events and one set of past data. To ask for the evidence of one theory that would presumably make that theory correct whereas all other theories would be incorrect, requires such “theories” to not be theories at all, but rather claims of historical events. Things like “Caesar, not George Washington, crossed the Rubicon, and THEN there was an increase in yearly reported alien sightings.”

    What you are actually asking is this:

    “Given that I am using one particular theory that is derived not from experience but a priori considerations, in order to understand history, and given that this theory is consistent with history, what is it about history according to you that I am missing or wrong about that would make me change my mind about which theory is the correct theory to use to understand history?”

    The answer to that question is: Nothing. If two mutually incompatible theories are both consistent with history, then it is impossible to use history to eliminate one theory from consideration.

    I could point your attention towards what it looks like for capital to have been malinvested. I could only say look around you. But you would invariably carry with you your own theory to understand what you are seeing, such that you would believe the data is somehow speaking for itself and showing you and everyone else that the problem really is not enough aggregate sums of ownership title transfers of a fiat issued medium of exchange from a coercive monopolist.

    The only way to settle theoretical debates is based ultimately on theory, not history.

    To answer your last question:

    Time.

    You have to take into account time. Accounting for malinvestment that used to be accounted for towards production and the statistics you observe, takes time to be re-accounted for towards liquidation, dismantling, and redeployment. Humans cannot instantly replace all the malinvested capital with new capital.

    The problem with your approach is that you are thinking in terms of aggregates. Not all aggregates are created equal. Aggregate output can rise even with impoverishment as capital is being wasted. Aggregate output can fall even with enrichment as capital is being reallocated.

    • Transformer says:

      “I could point your attention towards what it looks like for capital to have been malinvested. I could only say look around you. But you would invariably carry with you your own theory”

      I see capital unused (empty shops and factories , high unemployment etc). I would be genuinely interested in hearing what believers in ABCT would site as empirical evidence of mal-investment and that has caused the slump to last for so long. I know that their is evidence that housing was overproduced and that still has some overhangs – but my point is why isn’t there a robust year-on-year increase in RGDP as the previous mal-investments are corrected?

      “The problem with your approach is that you are thinking in terms of aggregates”.

      Hard to see how the concepts like “boom and “slump” have much meaning if we are not allowed to think in aggregates at least sometimes.

      • guest says:


        … why isn’t there a robust year-on-year increase in RGDP as the previous mal-investments are corrected?

        Because the government isn’t allowing the malinvestments to be corrected.

        I think this will help, because it addresses the “idle resources” argument, directly:

        Austrian Business Cycle Theory
        http://www.youtube.com/watch?v=5K4Os5eXPw4

        The evidence that malinvestments are taking place is that there is an artificial increase in the supply of money. Because of this, interest rates are going to be artificially lower. Because they are lower, more longer term (capital) investments are going to be taking place.

        Those sectors which are stimulated by the artificially low interest rates are the bubble sectors. Absent the artificial stimulus, resources would have been spent according to consumer preferences.

        • guest says:


          I think this will help, because it addresses the “idle resources” argument, directly:

          I gave the wrong link for this. The one I gave does not address the “idle resources” argument. This one does:

          Why You’ve Never Heard of the Great Depression of 1920 | Thomas E. Woods, Jr.
          http://www.youtube.com/watch?v=czcUmnsprQI#t=38m15s
          [Time stamped]

      • guest says:

        Consider Robert Wenzel’s response to a similar question:

        New York Fed: Leave the Building!
        http://mises.org/daily/6028/New-York-Fed-Leave-the-Building


        One economist asked me how I knew the housing market was going to crash. I responded that because of Austrian theory, I understood that money created by the Fed enters the economy at specific points and that it was obvious the housing market was one of the those points. I told him that I also knew that this would eventually result in price inflation (as the money spread through the economy) and that at that point the Fed would slow printing and the housing market would collapse, which is just what occurred.

      • guest says:


        Hard to see how the concepts like “boom and “slump” have much meaning if we are not allowed to think in aggregates at least sometimes.

        The boom and the slump only happen to those businesses and people who were misled by the artificial stimulus, so there’s no need to think of them as aggregates.

        System-wide recessions/depressions happen because the government stifle’s the market’s attempts to recover (price controls, for example).

      • Andrew' says:

        Capital is not “In this bucket we put the capital.”

        Capital is everything. We draw arbitrary lines between it and say:
        “We’ll call this stuff labor”

        But that includes human capital. Having too many people building their human capital in skills to build houses is a form of capital neglect.

      • Matt M (Dude Where's My Freedom) says:

        The existence of “unused capital” is itself evidence that malinvestments are still in the process of being corrected.

        An empty factory was a malinvestment. Forcing it to return to production when the profitability of the end product is in doubt would be continuing the malinvestment. Spoilers: That’s exactly what the fed has been encouraging throughout this entire “recovery.” They’re so focused on AD that they are artificially stimulating people to put resources to use that would not be profitable in the absence of intervention.

      • Major_Freedom says:

        “I would be genuinely interested in hearing what believers in ABCT would site as empirical evidence of mal-investment and that has caused the slump to last for so long.”

        But it isn’t SOLELY malinvestment that has taken place.

        We also have government intervention intended to “fix” the economy. That is a significant reason, if not the only reason, why the slump has lasted so long.

        “Hard to see how the concepts like “boom and “slump” have much meaning if we are not allowed to think in aggregates at least sometimes.”

        Well it’s not too hard, really. Think of booms as partial relative SEEN overexpansions of some firms and industries, and partial relative UNSEEN underexpansions of other firms and industries, which just so happen to lead to an unsustainably higher aggregate output for a temporary period of time. Think of slumps as reversals to this.

        You don’t need to group all industries into one blob.

        I can think of 100 individual people, in terms of individuals, and not just “one group” of individuals.

    • tesc says:


      “There seems to be plenty of evidence that insufficient AD has persisted in the current slump.”
      What is the evidence of insufficient money printing, ”

      Transformer said AD, not money printing. If velocity drops, as it has, AD does not move despite of money printing. Using MV=PY:

      AD=Y(P)= a+bP = a(M,V)+bP(AS)

      AD is different then M as you can see.

      In any way, almost no money has been printed. All the FED has been doing is exchaging interest earning assets (treasury bills) for another interest earning assets (reserves at the FED.) That is why Austrians got price inflation wrong. You guys thought monetary expansion creates price inflation necessarily, not if V of MV=PY drops.

      Interest on reserves droped V.

      • guest says:

        “reserves at the FED” = money printing:

        The Fed as Giant Counterfeiter
        http://mises.org/daily/4029


        At this point let’s review exactly what happens when the Federal Reserve buys Treasuries from private dealers. Let’s say the Fed wants to buy $1 million worth of T-bills from Joe Smith. So it writes Joe a check for $1 million, drawn on the Fed itself. Joe hands the T-bills over to the Fed, where they end up on the asset side of its balance sheet. Joe then deposits the check in his personal checking account, which goes up by $1 million.

        So at this point the Fed has increased the money supply by $1 million.


        In any way, almost no money has been printed. … That is why Austrians got price inflation wrong. You guys thought monetary expansion creates price inflation necessarily …

        If you print money, but don’t spend it, price inflation doesn’t go up:

        Where is the hyperinflation?
        http://archive.mises.org/12795/where-is-the-hyperinflation/

        Besides, inflation IS occurring in the stock market, the housing market, and the bond market:

        So Where’s the Inflation? Tom Woods Talks to Mark Thornton
        http://www.youtube.com/watch?v=n0RusrwYsRE#t=5m16s
        [Time stamped]

        Inflation Propaganda Exposed
        http://www.youtube.com/watch?v=pwI3Nya5L9g

        As well, the CPI is rigged to hide price inflation:

        Peter Schiff – The Fed Unspun: The Other Side of the Story
        http://www.youtube.com/watch?v=zdB9I79BQRI#t=1h20m12s
        [Time stamped]

      • Andrew' says:

        This is where I start to think ALL economists are CRAZY!

        If velocity drops, that changes EVERYTHING. That IS the economy. And you don’t think that everyone will have to do a lot of recalculating? But a lot of economists treat it like it’s nothing.

        Sorry for the caps.

        I didn’t get the inflation wrong, mostly because I didn’t think that far.

        • Andrew' says:

          I know this isn’t exactly right as representative, but go tell a grocery store manager that his turnover will halve. See what he says.

          If anyone can do that, I’d like to know.

      • Gamble says:

        you forgot to include junk and banks in your equation…

        “In any way, almost no money has been printed. All the FED has been doing is exchaging interest earning assets (treasury bills) for another interest earning assets (reserves at the FED.)”

        • Andrew' says:

          Not sure exactly what you mean, but I think Bernanke’s objective was to save the banks and inflation would have been a nice-to-have.

          The cycle is longer than we think, I suspect.

        • tesc says:

          AD = Y(P) = a[M (FED), V (Banks, Confidence)] +bP(AS)

          If you define junk I can include it.

  4. Bob Roddis says:

    I think it is terrible mistake when explaining one’s version of the ABCT to fail to mention in the introduction to the explanation the concepts of violent intervention, Cantillon Effects and economic calculation. Ultimately, malinvestments are caused by funny money which induces false prices and creates patterns of investments that cannot be sustained without further injections of funny money. These injections are (and must always be) temporary and unsustainable transfers of stolen purchasing power but the resulting (false) price structure deceives most everyone. Inadvertent capital consumption fundamentally occurs due to distorted prices. Further, when these problems appear it is always due to a prior violent interventions, not laissez faire. We have seen that the Keynesians and monetarists have no response this analysis and it was purposefully ignored by Keynes. There may be a good reason why our opponents and the general public have such problems understanding our analysis which is often presented like teaching calculus to people who do not understand the foundation of algebra (or even simple arithmetic). Except that basic Austrian concepts should be and can be made easily understandable for most people.

  5. Gene Callahan says:

    The truck fleet: excellent explanation! Well done.

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