For those who may be new to Austrian Economics, to better understand the ideas presented below, please first take a look at this web comic on capital theory from my series Human Action Comics
Probably what most sets the Austrian School apart from mainstream economics is the Austrian School's careful analysis of the structure of production. When an Austrian economist considers the structure of production, he doesn't just dwell on crude aggregates, such as the total number or total value of capital goods in an economy. Rather, h considers how long (or how "roundabout") a given structure of production is. He asks, "How many steps are there in the production process between the extraction of raw resources and the actual output of consumers' goods?" He also considers how any given society with a given structure production can improve its productivity.
Capital Accumulation and Social Progress
Any change in the structure of production obviously must either involve (A.) an increase of, (B.) a decrease of, or (C) a maintenance of its
length. Improvements in productivity which involve
less or equally roundabout production processes will tend to be adopted very quickly because they tend to require fewer resources. Therefore, all that is required for their adoption is their discovery. For example, it won't take long for a hunting society to realize that the hard, sharp obsidian in the area is better for skinning animals than the fragile, blunt pumice stones they may have tried to use first.
But once a society has plucked all the low-hanging fruit of "no-brainer" productivity improvements, what
then can its members do to improve productivity? Obviously the only thing left to do would be to adopt improvements in productivity which involve
more roundabout methods of production.
For example, a hunting society might try the more roundabout (but more productive) method of making and using bows and arrows for hunting to replace the less roundabout (but less productive) method of making and using crude spears. This is an investment in more productive capital goods. However, since making bows and arrows take more time, and perhaps more resources, the hunters and their investment must be sustained by an adequate stock of food and other materials, since, even though the bows and arrows will yield a greater bounty, they will only do so after a
longer period of time. Thus, savings are an indispensable prerequisite for increases in productivity which involve lengthening the structure of production.
Or, as Ludwig von Mises explained in
Human Action,
chapter 18, section 3:
As soon as those present wants are sated the satisfaction of which is considered more urgent than any provision for the morrow, people begin to save a part of the available supply of consumers' goods for later use. This postponement of consumption makes it possible to direct action toward temporally remoter ends. It is now feasible to aim at goals which could not be thought of before on account of the length of the period of production required. It is furthermore feasible to choose methods of production in which the output of products is greater per unit of input than in other methods requiring a shorter period of production. The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.
This "further progress" is possible due to the fact that more bountiful production methods mean more goods, which in turn mean a greater capacity for savings. The new saved goods can be used, not only to maintain the new, longer structure of production (by replacing bows and arrows as they are spent), but can also be used to support an even
longer and
more bountiful structure of production (say, in the case of the hunters, building and using extensive traps). The savings made by possible by the
second productivity-enhancing lengthening of the chain of production can then in turn be used to for a third such lengthening, and so on. In a free market, this virtuous cycle of capital accumulation can go on in perpetuity, thus engendering an upward spiral in the well-being of mankind.
But as Mises wrote later in the same section, no matter how high up the spiral we may be, we always owe the propitious opportunities at hand to the capital accumulation of those who came before us.
Every single performance in this ceaseless pursuit of wealth production is based upon the saving and the preparatory work of earlier generations. We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today. We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future. If the sons of these legendary fishermen had worn out these intermediary products--nets and canoes--without replacing them by new ones, they would have consumed capital and the process of saving and capital accumulation would have had to start afresh. We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.
It is just such an upward spiral as mentioned above that the western world experienced during the Industrial Revolution. And as Mises further elucidated in
chapter 18, section 4, the rapid rise in western living standards during that time was a function of
capital accumulation.
To have capital goods at one's disposal is tantamount to being nearer to a goal aimed at. An increment in capital goods available makes it possible to attain temporally remoter ends without being forced to restrict consumption. A loss in capital goods, on the other hand, makes it necessary either to abstain from striving after certain goals which one could aim at before or to restrict consumption. To have capital goods means, other things being equal, a temporal gain. As against those who lack capital goods, the capitalist, under the given state of technological knowledge, is in a position to reach a definite goal sooner without restricting consumption and without increasing the input of labor and nature-given material factors of production. His head start is in time. A rival endowed with a smaller supply of capital goods can catch up only by restricting his consumption.
The start which the peoples of the West have gained over the other peoples consists in the fact that they have long since created the political and institutional conditions required for a smooth and by and large uninterrupted progress of the process of larger-scale saving, capital accumulation, and investment.
Of course what ultimately matters for the well-being of society is the actual degree to which our wants are satisfied, and therefore the
actual usefulness of goods. Of course we can only know the actual usefulness of goods in hindsight. Acting man, therefore, must rely on his
anticipation of the actual usefulness of goods. Of course, man is not prescient, so he will often err in his anticipations. The more he errs, the more he will adopt structures of production that are either (A.) not as long (and productive) as he could have afforded, or (B.) longer than he can sustain and see through to completion. As an example of (B.), a hunter who incorrectly measured the length of rope in his possession might embark on building a kind of trap which required more rope than he actually had. He would, of course, be unable to finish the trap, and any of the rope that was cut into lengths that were unusable for anything else will have been wasted.
Central Banks and Social Retrogression
The Austrian Business Cycle Theory, first formulated by Mises in 1912, teaches us that in a developed economy, artificial expansions of the supply of money and credit (which now are the exclusive prerogatives of central banks) temporarily lower the rate of interest which leads to mass error. It causes people to think, like the hunter with poor rope-measuring skills, that they are wealthier than they truly are, which leads them to over-consume, and invest in production processes which are
too ambitious given the capital goods available.
Let's say a hunting society using crude spears is at Level 1 of capital accumulation. Bows and arrows are used at Level 2, and traps at Level 3. Using such a scale, an industrial society would have to be characterized as several orders of magnitude above these levels. So let's use a different scale for such societies. Let's say in the early phases of its first industrial revolution, a given society was at Level A, and, through capital accumulation, it subsequently advanced to Level B, then C, and so on.
Now let's say that the society at some point is cursed with a central bank. At the time of the central bank's first expansion of money and credit, the society is at Level Q. Again, artificial expansions of the supply of money and credit make the members of society think they are at a more advanced level than they really are. It makes them think they have sufficient capital goods to see through longer, more productive production processes, when they really don't. And so let's say the monetary expansion is sufficient to make the members of the society think they are at Level R, instead of Level Q. They make Level-R-appropriate investments which are simply unsustainable; they are going through an economic bubble. The reality of the situation will eventually reveal itself to the members of society. That is the moment of the "bursting of the bubble".
Now you might think it would then simply be a matter of reallocating the capital to Level-Q-appropriate production processes. But that presupposes capital as an amorphous blob, like a mass of clay, which can be divided up and merged together to any purpose. But just as the shaft of a curved bow makes a wretched spear, and much of the materials of a animal trap are useless for the production of bows, most of the investments made during a bubble are simply lost. As Jim Fedako has beautifully
put it:
The standard view is that capital is clay, ready for the potter to reshape it in a moment's time. In contrast, the Austrian view takes the current structure of capital as a given, something that the entrepreneur must take into consideration when formulating his plans. If an entrepreneur wants to change the current structure of capital, he will wield dynamite and dozer, not water and wheel.
And so, having squandered resources, our hypothetical society which was acting as if it was at Level R, is more likely to find itself taking two or more steps back, not one, and may, at best, need to adopt Level-P-appropriate methods of production.
That is of course,
unless the central bank expands money and credit even further, making them think Level Q is still viable. Then it will just continue to squander resources, and continue to drop level after level until the central bank finally leaves bad-enough alone.
And of course it is not just how long the central bank fosters malinvestment that matters, but how
intensely it does so. The greater the degree to which the central bank expands money and credit, the worse will be the resulting malinvestments. It should be obvious that an unsound production process adopted by a businessman who thinks he's three times as wealthy as he really is will squander
more resources than one adopted by a producer who thinks he's only two times as wealthy as he really is.
Our Present Crisis of Interventionism
What does this mean for us in our present situation? The longevity and the intensity of the monetary and credit expansion embarked upon by the Federal Reserve since the beginning of Alan Greenspan's term at its helm has been unprecedented. Compared even with the levels of monetary and credit expansion during the 20s and 30s, what Greenspan did after the dot-com bubble burst, and what Bernanke is doing following the bursting of the housing bubble has been stratospheric. In the space of months, Bernanke
doubled the Fed's balance sheet. Through engendering massive
capital consumption, these measures have destroyed prodigious amounts of wealth, and continue to do so today.
Regarding the true wealth of society, nobody can say exactly how many "alphabet-levels" we've fallen, or will fall. But it is will very likely be enough to result in a calamitous long-term plummet in the living standards of the average person. This will very likely bring us to the climax of what Mises called the "
Crisis of Interventionism".
Before the rise of liberalism made continuous capital accumulation possible across generations, the common man held a gross underestimation of what his own species was capable of. He simply took it for granted that economic stagnation
across millennia was simply an inevitable fact of life. He had no inkling that human society was capable of enormous strides in the standard of living within a
single decade. If the average man had any notion of it at all, he would have shrugged at the fact that his own standard of living was not much different from that of the average man a dozen generations before him, or, for that matter, from an even more ancient forebear 1,000 years prior. And if the ruling caste lived high on the hog while the bulk of the populace remained mired in squalor, well that was just a fact of life, too.
But that has irreversibly changed. The phenomenal increases in the well-being of man of the past centuries have exploded such lies. The common man knows he and his fellows are capable of wondrous achievements.
And so, years from now, after the ceaseless and prodigious capital consumption engendered by the Federal Reserve and other government measures has reduced society to squalor again, the common man will not accept it. The ruling caste may insist to him that The New Squalor is simply a product of circumstances brought on by the recklessness of certain private individuals, and that the maintenance of its own power and position are necessary to keep things from getting even worse (as the Fed is doing even now as it is confronted with but a mild curtailment of its powers). But the common man will not believe them. He will not accept a return to the old order. He has already tasted the fruits of capital accumulation. He knows civilization is capable of more than this, and that somewhere there
must be a wrench in the gears of society: a problem too fundamental to be explained by just the reckless investing or heedless consumption of certain private individuals at a certain point in time. He will desperately look for this wrench, even if it means abandoning some of his most firmly-held beliefs about government and society. He already knows from history that the students of Marx can't help him find it. And he will come to realize after a string of failed economic rescue attempts that the students of Keynes and other mainstream economists don't know where it is either.
But, if he survives long enough, and if society does not descend into barbarism first, the common man might find the answer to his conundrum in the writings of Ludwig von Mises and his students. And he will learn from Mises that the wrench in the gears of civilization is nothing else but the interventionist state. He might then even find the will and the nerve to yank out the wrench for good.
Or he might not, and all will be lost.
As the state brings the world deeper into the Crisis of Interventionism, civilization itself is nearing a fork in the road. It will be Mises or bust.
