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Introduction to Austrian Economics
Podcast surveying the basic concepts of Austrian Economics.
Not More Capital — the Right Capital
Capital goods are parts of an unfinished plan.
Of all the unique contributions of the Austrian school of economics, none is as central as the theory of capital. Other economists have consistently misunderstood that theory, leading to much confusion, particularly in the two controversies that defined Austrian economics in the twentieth century: the socialist calculation debate and the Hayek-Keynes debate. Even today, mainstream economists commenting on the Austrian theory of the business cycle misunderstand these issues.
Austrians start by defining capital as, in Israel Kirzner’s words, “unfinished plans.” Capital is all the elements of an entrepreneurial plan that have to be combined to produce final output, including labor (sometimes called “human capital”), machinery, raw materials, and intangibles such as particular business processes a firm uses or its connections to suppliers.
When we see capital this way, we also recognize that capital goods are heterogeneous things. Capital is not like a bucket of water from which we scoop identical cups. Instead, capital goods, including human capital, have a limited number of specific uses to which they can be put. As Peter Boettke puts it, capital is not like Play-Doh, which can be formed into any shape, but like Legos, the versatility of which is limited by the sizes, shapes, and interconnections of the pieces.
Austrians speak of the need for capital to be “complementary” to other capital in order for it to help create an integrated production plan. A producer must have the “right” capital, that is, capital that “fits together.” An important implication here is that “more” capital isn’t always better. What firms need are pieces that fit, not just duplicates of what they already have.
Complements or Substitutes?
Consider the major sports story of the last few weeks: LeBron James’s move to the Miami Heat of the NBA. At first blush, this seems like a huge gain for the Heat because they now have two of the best players in the game — James and Dwyane Wade (and perhaps a third, Chris Bosh). Economically, it might look like the Heat will be much more “productive” because they’ve added very productive human capital in the form of James. However, from an Austrian perspective there’s a question worth asking, as Tyler Cowen has pointed out: Are James and Wade complements or do they just substitute for one another? If they play too much alike, will they “fit together” in the way capital goods need to? Often the best teams in sports are ones that find good “role players” who complement one or two excellent players.
If James and Wade, for example, can’t play defense well enough or they both like to handle the ball too much, and no one else on the Heat can pick up the defensive slack or move without the ball, there will be a hole in the production plan. Having more really productive capital isn’t useful if it is just a substitute for what you already have rather than a complement in the mixture of capital goods that are needed to produce the output. In fact, what makes capital productive is precisely that it is complementary to other factors of production.
All these points are misunderstood by critics of the Austrian explanation of the recession. What Austrians claim happens during the boom is that inflation drives down interest rates, creating malinvestment as entrepreneurs begin production processes with too many stages between inputs and outputs (which seems to be justified by the artificially low interest rate). Labor gets allocated to those industries as well.
Notice that it’s not that they have over-invested in capital. Rather they have the wrong mix of capital. If one doesn’t understand the heterogeneity of capital, that distinction is easy to overlook.
It also explains why the road to economic recovery is not a matter of just more spending and more investment in general. Capital and labor need to restructure themselves to meet the new reality of the post-crash marketplace. Just throwing more capital at firms won’t help; neither will trillion-dollar government spending on consumption or job training. Only the discovery process of the market can reveal which specific capital goods and what sorts of labor are required for entrepreneurial plans to succeed in the current economy.
We don’t need “more” capital and labor. We need the “right” capital and labor. Figuring out what’s right is what markets do better than the alternatives.
Comment by Guillermo Barba on 22 July 2010:
Excellent article. At the bottom of the interventionistic efforts is the belief that free markets are inherently unstable and unjust, and therefore ‘doing something’ is both a sign of being proactive, moral, and enlightened.
Pingback by “Planes sin terminar”, el capital según la escuela austríaca « Sólo Historias on 22 July 2010:
[...] de los ciclos económicos, sino que lo dejé en programación para mañana, es que al leer hoy una columna sobre la teoría del capital (en las líneas de la misma escuela de economía) me cayó en cuenta [...]
Pingback by (Unofficial) Recession: When Will it End? | Practical Praxeology on 23 July 2010:
[...] http://www.thefreemanonline.org/headline/right-capital/# [...]
Comment by Mandeville on 24 July 2010:
No offense to Mr. Horwitz, but his talk of “right” capital is ridiculous. We have outgrown direct exchange.
A stronger point that needs to be made is that capital availability needs to come strictly from individual savings and be subject to a market rate of interest in order for it to be efficiently allocated so that mal-investment is avoided. In today’s world, capital is printed by governments and has little to do with real savings. Governments create artificial demand which leads firms to believe that they need to expand their production capabilities.
What the true meaning of “right” capital is is that it should come from real savings. With fractional reserve banking, this is impossible. Fractional reserve banking and other forms of government monetary expansion is what causes the existence of booms, busts, recessions, depressions, and even the ordinary business cycles. They are all types of “wrong” capital made available for what in all cases will eventually found to be wasteful.
Comment by Steve Horwitz on 25 July 2010:
Mandeville,
I agree with everything you say above, except for the claim that fractional reserve banking is a form of government monetary expansion. Fractional reserve banking is NOT a creature of government, but an evolved market contractual arrangement. When governments monopolize money, fractional reserve banking makes matters worse. But when money production is privatized, there’s nothing wrong with fractional reserves. So put the blame where it belongs: on the government intervention, not the fractional reserves.
Everything else you say is right on and I don’t see how you think it’s at odds with my argument in the article.
Comment by Matt Hickok on 26 July 2010:
Capital theory? What’s that? But seriously, this is a good article and it’s nice to see that there are still economists willing to talk about capital. I’ve always thought that it’s funny how the “professional economists” claim that they have the sophisticated theories while simultaneously rejected any complexity in the structure of production (I blame Mr. Clark). How can an someone be taken serious while ignoring shrugging off (not opposing) the specificity of capital? Even back on the 60s we had top economists like Joan Robinson, Sraffa, and even Paul Samuelson debating the issue (Though you can probably go through graduate school at Harvard and still never hear of the Cambridge capital controversy). At least we still have some primitive economists that are willing to tackle such issues.
But in response to your response to Bernard, I completely agree. The whole anti-fractional reserve mentality that dominates in many Austrian circles seems like one big misunderstanding to me. The Austrian theory of the business cycle seems to be based on mis-allocation of resources which results from manipulated interest rates in the fractional reserve system. But the issue comes from the manipulation of the reserves, not the fractional reserve system itself. Even with the view that money is non-neutral, it is a non-sequitur to state that fractional reserve result in a business cycle. More savings, lower interest rates, more goods, and savings to buy the goods. Sure, you may think that the money multiplier from the fractional reserve increases the prices, but at the same time doesn’t the increased production from the increased investment of capital goods lead to lower prices? I don’t see how a business cycle can be derived from this process.
But I think many of the Rothbardians see it as more of a moral issue than economic. I’ve always thought that’s goofy considering they believe you can sell your body with a legitimate contract but can’t sign a legitimate contract to have your bank loan out your savings and be paid interest.
Okay, I’ll shut up now.
Comment by Tom Grey on 16 January 2011:
This was a fine article to be translated into Slovak, too. Although I doubt most Slovak NHL hockey lovers really follow the personalities in the NBA so much (baseball and Am-football even worse!).
I think mal-investment will also occur in any economy that allows investment. The Tulip mania was not central bank caused.
I’ve moved away from the Austrian school (of my college days) as I consider the likely tradeoff between a fairly well functioning central bank and free banking/ gold standard.
My guess is that with better run (maybe NGDP targeting?) central banking, the global economy will average growth at some 3%/year over 20+ years, although there will be 4% plus periods and some crashes with minus -1 or even -2% in terrible years, after a bubble.
Without central banking, there will be much less mal-investment, but also much less investment. So growth averages only 1%/year over 20+ years, including some 0% crashes.
Without central banking, there would have been a smaller dot.com bubble in the 90s, and a smaller housing bubble in the 00s. And smaller overall growth, too. But there would be bubbles.
The bubbles are most fundamentally caused by mal-investment contracts about the future — one side gets certain cash today, the other gets an asset or promise they expect to convert to cash in the future. The easy money just makes it easier to make bad bets.
The Financial Crash was caused by AIG & other Big Banks being insolvent — making Big contractual obligations about an uncertain future event in order to get small cash today, but those events then happening. Even in Anarcho-Capitalism, there needs to be some mechanism to use force on the rich to pay for their promises when their expectations fail. If a “private enforcement” agency, there needs some other agency to ensure the private enforcers also fulfill their duties. As a minarchist, it’s clear there will be “enforcement” agencies, and I’m happier with them being honestly called government. In fact, that is the key job of gov’t, which they failed to do — enforce contracts that the rich agree to but, at some time, prefer not to honor.
(Thanks for the opportunity to rant here, maybe will add it to my own blog, too. Thanks for your Bratislava visit, again!)
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