Capital Consumption

Economics Economics Questions
1

I’ve been pondering Bob Murphy’s article The Importance of Capital Theory where he tries to show that during the “boom” phase of the business cycle people feel wealthier because they actually consume more. The credit expansion results in businesses unknowingly consuming capital which increases the production of consumer goods albeit in an unsustainable manner. Eventually capital is completely used up and production collapses.

His sushi example, however, doesn’t seem to relate to the actual business cycle.

I can see how capital that would normally be used to replace the depreciating stock in the stages of production closest to the consumer would be bid away from those stages (via the credit expansion) to stages farther removed from the consumer. However, as I see it, this would not result in an increase in the production of consumer goods, rather they would continue to be produced at the current rate (with capital depreciation). This is, of course, in addition to the increased production of capital goods in the later stages of production. To me, this is what gives the feeling of a “boom”. That the stages of production expand without people having to curtail present consumption.

My question is what leads Murphy to believe that additional consumer goods will be produced?

2

I think Murphy’s example resembles more a widening of the structure of production (namely, first-order capital goods), versus just a lengthening of the structure of production. The following post is semi-relevant, as it brings the widening of the structure of production into account: Revisiting Austrian Capital Theory and the Present Recession.

3

Perhaps Bob’s sushi example could have started even before the ‘boom’ in the sectors closer to sushi eating. Say, a boom in motorboat making that would have brought about ‘forced saving,’ that is, a depletion of sushi. Bob might have realized that the analogy kind of dies when trying to come up with a parallel for the initial expansion of credit which bids the prices of investment goods and lengthens the structure of production.

Either way, his main focus is in trashing Krugman, whose proposal is to boost consumption, so it is more fitting that Bob’s story begins during a later phase of the boom, where it is already goods closer to consumption that are thriving, and pressure is already building to sustain such consumption even without the requisite higher-order stages.

For purposes of making his point, Bob speaks of sushis increasing in comparison to before Krugman’s intervention. But as far as I know, the Austrian theory does not suppose an increase of goods, whether first-order, higher-order, or aggregate. What Hayek focuses on is the ratio between resources for investment and those for consumption.

So if the original pre-Krugman I:C ratio was 4:2, the Krugman intervention would shift this to 2:4. Even if sushis don’t increase in number, the resources devoted immediately to them are more than that for motorboats and stuff. Obviously, the investment resources are not enough to sustain sushi, and eventually consumption would be reduced to 25% of the ‘consumption boom’ period, that is, the ratio will go back to 2:1 (which is equal to 4:2).

I don’t know if this helps your contemplation of the matter, but I do realize now that Bob’s article is definitely wanting if you’re looking for a complete explanation, particularly due to the absence of a central bank parallel. But thank goodness we have Hayek and De Soto to provide their expositions.

Jonathan, hi I’m Francis B.'s friend from the Philippines. I read your article, and it’s always enjoyable to read about ‘modern’ ways of understanding ABCT. It goes to show that reading theory from the greats is not enough; the ability to interpret situation to situation is just as important to gain understanding of phenomena.

I myself am inclined to see the housing bubble as an investment boom. But the beauty of ABCT is that you can derive understanding of the crisis whether you consider houses as capital goods or as consumer goods. They were capital goods in the sense that the mortgages financed the large financial institutions and thus stimulated investment; also because the houses were often held on to in the hopes of greater returns in the future.

They were consumer goods in the sense that people borrowed on their houses in order to finance their consumer goods’ expenses, and also because people actually lived in the places they bought.

Goes to show how a good analysis may be flexible with regards to treatment of the variables considered (e.g. whether houses are consumer or capital goods), but nonetheless logical in the exposition (e.g. the boom depletes resources nonetheless).

4

Due to technical problems, Mr. Murphy has asked me to post his reply for him:

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My claim that consumption increases during the boom is consistent with Garrison’s PowerPoints, Mises’ treatment in Human Action, and Joe Salerno’s recent paper:

http://mises.org/media/4978

5

Bob thanks for the reply. I listened to Salerno’s lecture, but I’m still having a hard time getting my head around this. Maybe its just me.

I get the concept of illusory profits, and can see how demand for consumer goods could increase, but without increased production of consumer goods no one can actually consume more, right? In order for people to consumer more, more consumer goods would need to be produced. Which means the later stages would need to be expanding production during the boom while the earlier stages are also expanding. All of this funded by using capital that would otherwise have been used to replace the depreciating stock. Do I have this right?

6

This is the problem in the long-run. During the boom, in the short-run, both consumption and investment rise relative to real savings. The savings/consumption trade-off and the investment/savings relationship are temporarily eliminated due to credit expansion beyond the demand for money. Additionally, as market interest rates are reduced below the natural rate, consumption and/or other speculative investments become more lucrative (individuals will either consume higher portions of their income rather than having it inflate away in the banking system, or they will attempt to protect their savings via indirect finance/speculation, or a combination of the two). The bust occurs precisely when consumption rises relative to investment, which reveals that there are not enough resources in the economy to complete the malinvestments (either on time or at all).

Additionally, during the boom phase, the prices of both consumer goods and producer goods are rising, but the latter is rising at a faster rate relative to the former. The general price inflation of all consumer goods lowers the real income of laborers (they receive the newly created sums of money last). Thus, consumption is rising relative to savings, but is actually falling in absolute terms (both savings and consumption are falling in absolute terms, but the former is falling at a faster rate, while investment is rising in absolute terms). During the inflationary boom phase, the vast majority of individuals are becoming poorer as they consume capital and waste scarce resources by investing in ultimately untenable long-term projects (malinvestments).

The bust merely reveals this fact and attempts to correct the structural imbalances. But even if the bust succeeds completely, society will be absolutely poorer. Perpetual inflation, at increasing rates, is the only way to delay the inevitable correction. There’s also a whole international dimension that complicates this process (namely the fact that China, for example, finances much of America’s malinvestments and consumption by forcing their citizens to save due to currency devaluation and capital flight).

7

I think Roger Garrison’s slides on Hayekian Triangles and whatnot are very informative. Chris, perhaps if you thought of the issue in terms of time-preference? At any rate, this is the way I am given to understanding things:

First, the lengthening of the structure of production is induced by an alteration in the supply of loanable funds with the end effect of lowering the interest rate. This is “capital” injected on top of real savings, adding to the pool of funds available for maintaining depreciating capital and expanding production.

From the entrepreneur’s perspective a lower interest rate makes it more appealing to invest in production process that increase the amount of time, or complexity of the steps in between inputs and finished consumer product. It allows the entrepreneurs to indulge their plans/designs that lie further out from the present in their time preference.

Now from the consumer’s perspective, because the increase in supply of loanable funds occurred not because of increased saving, but because of an injection of fiat from the central bank, the lower interest rate reduces the incentive for individuals to save and encourages indulgence of their more present concerns as determined by their time preference. More consumption.

So there are two forces at work: One sends a signal to the entrepreneur signalling that projects with more distant payoffs have become less risky, while the other signals to consumers to divert more funds to immediate consumption, increasing demand.

The rub in all of this lies in the fact that the injection of supply into the loanable funds market is actually debt. Once this starts to be paid down the money supply contracts registering as a broadly higher interest rate, lowering consumption and choking growth at the same time.