In other words, can the new structure of production be in effect before the fall in consumption? Can the production that this new capital (or more roundabout method of production) is responsible create more consumption that would offset the fall in consumption that is due to the forced saving of the artificially low interest rates? This was one of Piero Sraffa’s main arguments against Hayek’s theory of the trade cycle. In going through a though experiment yesterday, I think I’ve shown that at least in the worst-case scenario (no savings, living on the verge of starvation), that this is not possible, that the new production cannot avoid the fall in consumption problem brought about by forced savings.
I once read an example about an island economy. It was something simple where there were some boats, some fishermen, some people who did maintenance on the boats, and some people who cooked the fish. People were perfectly content with the fish and they caught enough fish just to maintain sustenance. The one day, a motor washed up on shore. Now, less fishermen were needed because the boat was much more efficient. Only 1 boat was used now. In fact, more fish were caught by less fishermen, so some of the fishermen and maintenance workers decided to work on jewelery or something else unnecessary. But then one day, the engine stopped working (either because it ran out of power or the natives didn’t know how to maintain it). So now what? The boats have fallen into disrepair because that one boat was used and now the some of the natives will starve because that original production cannot be reached right away. You have a crash.
I have a few problems with the story though. First off, it seems obvious that the natives should have predicted that the engine would not have lasted forever. It’s likely that an entrepreneur would have kept up the maintenance of the boats because of the anticipated crash of the motor. But then again, he would have had to have accumulated some savings in order to do this, and in the now richer island, he may have been able to do this. So right away, for me at least, this story seems to fall flat as an example of the failures of Keynesianism. And for good reason, it doesn’t model the artificially low interest rates that Keynesians recommend. The engine was real wealth and it did not depend on the production of the natives.
So, I’ve come up with a much more accurate example of how the proposed Keynesian idea would work on the island. But the problem is, it’s not much of a story without money. Basically, the only way to get this engine would be to sacrifice some production somewhere. Some workers have to stop fishing, doing maintenance, or cooking. Sacrificing from fishing or cooking would lead to instant starvation because production is right at subsistence level. So then, the only place to take production from is maintenance. But the problem is this: can the workers produce the motor before a boat falls into disrepair and people start starving? If it was possible, then they would have already been producing engines. If not, then they are stuck with their inefficient man-powered boats instead of motors. So, if they are not already doing it, then it is obvious that they are stuck in that mode. So, in the barter economy, increasing production is not possible without outside intervention.
With outside intervention, they could get a loan to pay for a motor then sell the excess fish as repayment of the loan. The island would then grow richer because the excess fish could pay for oil and some workers can now do other work. But anyway, outside trade is not a part of this discussion.
So, let’s say the islanders use money. The fishermen sell the fish to the cooks, and they get money. They use that money to pay for cooked fish and for maintenance. The cooks eat some of what they prepare and maintenance uses their money to pay for cooked fish. Everything is in equilibrium. But now lets say you print some extra money and loan it out. Presumably then, someone will take the loan and try to construct an engine. If that person hires fishermen to build it, then people will starve. If that person hires cooks to build it, then people will starve. The amount of money in existence cannot change this fact. But, what if the maintenance workers are hired? Then some maintenance workers are hired to build the engine. But wait, didn’t we determine before that the workers could not build the engine faster than the boats would deteriorate? The loan does not change this. There was no savings to support this project: no excess fish. Once this project is started, people will starve. Looking at aggregates (yes, I hate to use it, but it’s the only way I can avoid death, which really isn’t useful to the picture), there was no savings. In order to pay for the new production, capital was needed. Since people weren’t saving, forced savings was introduced. The amount of goods available to people decreased because present production (boat maintenance) was sacrificed in order to get higher production in the future (the engine). When you try to loan with no savings, you decrease the amount of consumer goods available. Consumption decreases, and a crash ensues (people have to die in order to adjust to the new amount of production possible).
Trying to loan above the amount of savings: it will only lead to a crash. The islanders could not have increased production without saving.
My only problem now stems from this idea: what if the people are not living at the edge of starvation and what if there is some savings? In that scenario, could the new production possibly outstrip the effect of fall in consumption due to forced saving?