The Cambridge Capital Controversy (CCC) is sometimes cited as one of the strongest refutation of the Austrian Business Cycle Theory, considered by Mark Blaug as “the final nail in the coffin of the Austrian theory of capital”.
We must first point out that the “reswitching controversy” is empirically refuted. From Zonghie Han and Bertram Schefold (2005) :
An empirical investigation of paradoxes: reswitching and reverse capital deepening in capital theory
This paper examines the empirical relevance of the capital controversy. The price model of Sraffa and the dual models of the price and quantity systems of von Neumann become the basis of the investigation. In the course of the controversy, it proved easy to construct theoretical examples which contradicted the fundamental neoclassical hypothesis of an inverse capital demand function. This paper presents empirical examples for the first time. Thiry-two input-output tables from the OECD database serve as data. As a result, one envelope is found which involves reswitching. Reverse substitution of labour or reverse capital deepening are observed in about 3.65% of tested cases: they involve at least two switchpoints.
Theoretically, Guido Hülsmann, in “The structure of production reconsidered”, (if you are very familiar with the fundamentals of the ABCT, just start reading from page 13 “Two Critical Annotations”) had investigated the issue. He explains that the interest rate and the production structure are not necessarily negatively related (i.e., a lower interest rate is related to a lenghtening of the structure of production) even though the interest rate still affects relative spending, as theorized by austrians. Because the ABCT was too restrictive, he proposes to develop and enrich the theory of the structure of production. He lists 8 possible scenarios, each of them having different implications. He finally investigates the implication of the consumer credit and the variation of monetary conditions. The former simultaneously thins and lengthens the structure of production. The latter has no systematic impact on the structure of production.
Interestingly, the scenarios implying a drop of the PRI also involve higher relative spending toward the upstream stages. The eight scenarios can be summarized as follows :
Scenario 1° : increase of savings at a constant demand for savings, lower PRI, increase in gross savings rate, lenghtening of the structure of production, monetary revenues fall, real revenue of savers-investors increases, real revenue of owners of original factors increases more strongly.
Scenario 2° : increase of savings and of demand for savings, constant PRI, strong increase in gross savings rate, lenghtening of the structure of production, monetary revenues fall, real revenue of owners of original factors increases, real revenue of savers-investors increases more strongly.
Scenario 3° : increase of savings at a constant demand for savings, strong decrease of the PRI, increase in gross savings rate, no lengthening of the structure of production, activity shifts from stages of production downstream to stages of production upstream, monetary revenues fall, real revenue remains constant for savers-investors while increasing for owners of original factors.
Scenario 4° : increase of the demand for savings with no increase in savings, higher PRI and gross savings rate, lengthening of the structure of production with a thinning of the higher stages (with exception of stages newly created), monetary revenues fall, real revenue increases for savers-investors while remaining constant for owners of original factors.
Scenario 5° : decrease of savings with increase in demand for savings, higher PRI, constant gross savings rate, lengthening of the structure of production, relative spending diminishes toward the upstream (with exception of stages newly created), monetary revenues remain constant, real revenue increases for savers-investors while diminishing for owners of original factors.
Scenario 6° : increase of savings with decrease in demand for savings, lower PRI, constant gross savings rate, shortening of the structure of production, relative spending increases toward the upstream (with the exception of the stages that disappear), monetary revenues remain constant, real revenue diminishes for savers-investors while increasing for owners of original factors.
Scenario 7° : decrease of the demand for savings at a constant supply of present goods, lower PRI and gross savings rate, shortening of the structure of production, widening of the higher stages (with the exception of the stages that disappear), monetary revenues increase, real revenue increases for savers-investors while remaining constant for owners of original factors.
Scenario 8° : decrease of savings at a constant demand for savings, higher PRI and a lower gross savings rate, lengthening of the structure of production with a thinning of the higher stages (with exception of stages newly created), monetary revenues increase, real revenue remains constant for savers-investors while decreasing for owners of original factors.
Scenarios 1°, 2°, 3° and 4° entail higher growth, 5° and 6° have no impact on growth, 7° and 8° entail lower growth.
Capital-Based Growth: Basic Mechanisms
[…] (1) A change of relative spending between upstream and downstream stages may result from the mere lengthening of the structure of production – that is, even if the PRI does not change. The creation of additional stages upstream ipso facto changes relative spending within the structure of production. The new stages create producer goods that make human labour in the downstream stages more productive. The lengthening therefore tends to entail growth.
(2) There can also be a change of relative spending within the time structure of production that results from the decrease of the interest rate. If the PRI drops, there is a simultaneous widening of the upstream stages resulting from greater expenditure, and a thinning of the downstream stages resulting from decreased expenditure. Even if the overall length of the structure of production did not increase, the relative widening of the upstream stages would have a similar effect as the previously discussed lengthening. It would attract more labour and capital upstream, thereby increasing the output of producer goods that make human labour in the downstream stages more productive. Hence, a relative widening of the structure of production, too, tends to entail growth even if the overall length of the structure of production does not increase.
(3) Finally, increases of the gross savings rate, even if they do not affect relative spending between the different stages, increase investment spending and therefore increase the revenues of employed as compared to unemployed factors of production. They therefore create incentives for the owners of hitherto unemployed factors to sell respectively rent them out on the market. In short, increases of the gross savings rate tend to make more factors of production available, thereby increasing the total physical output of the economy.
[…] Sometimes the mechanisms work in opposite directions. For example, a drop of the demand for present goods entails a lower PRI and a lower gross savings rate than would otherwise have occurred. The lower PRI then increases relative spending in some of the upstream stages and on that account entails growth, whereas the drop of gross savings reduces factor revenues and therefore factor employment.
Scenarios of Growth and Distribution
Growth Scenario I
Let us start our analysis with the scenario conventional Austrian scenario of savings-based growth. It is characterised by an increase of the gross savings rate at a constant demand for present goods. This entails a drop of the PRI and also a lengthening of the structure of production. Hence, this scenario has the unique feature of positively combining all three basic growth mechanisms. It is therefore the strongest possible growth scenario. […]
How does this scenario affect monetary and real revenues in the new final equilibrium? What can be said about its impact on the final distribution of revenues? The general tendency of monetary revenues is to fall, because the vigorous growth occurs at constant monetary conditions, thus entailing a significant drop of the price level (growth deflation). This fall will be most moderate in the case of the owners of non-specific factors such as labour and energy resources (coal, gas, etc.). Their monetary revenues will tend to equal their discounted marginal value product (DMVP), which is roughly speaking equal to the arithmetic product of their marginal physical product (MPP) and the price of this physical product, divided by the interest rate. 16 In the present scenario, the MPP increases whereas the interest rate falls. On that account, therefore, the DMVP of factors of production tends to increase. However, the falling price level entails an opposite tendency, so that on that account the DMVP of factors tends to diminish. Again, the overall result depends on the particular situation of each factor. Some non-specific factors might end up earning higher monetary revenues, while others will earn less than before. The general tendency is for a slight decrease because of the strong drop of the price level.
The owners of specific factors of production used in the upstream stages might even end up earning higher monetary revenues. This depends on the extent of the increase of the savings rate. In Figure 22, we see that, in the new equilibrium, monetary spending is higher in some of the upstream stages than before, and that it creates entirely new incomes in the additional stages created most upstream. However, consider the following variant of Growth Scenario I, in which the gross savings rate drops so much so that it diminishes spending in all but the new stages:
In this case it is likely – though not necessarily the case – that all factors except for the specific factors used in the new stages will earn lower monetary incomes than before.
What about savers-investors? Their interest incomes are subject to two opposite forces. On the one hand, they save and invest more and on that account obtain more interest payments. On the other hand, the interest rate drops and on that account they earn lower interest payments. The overall result depends on the particular circumstances of each case. We therefore have to say that the present scenario does not have any systematic implications for the monetary revenues of savers-investors.
Now let us turn to the new final distribution of real revenues. From the outset it is clear that the latter will strongly increase in the aggregate, because total monetary spending remains constant whereas the price level plunges. For savers-investors this implies that their real revenues will tend to increase. As we have seen, their monetary revenues will not be systematically affected, and thus the drop of the price level entails a tendency for their real interest revenue to increase. The increase of real revenues is even more clear-cut in the case of the owners of original factors. Indeed, their real revenue tends to be equal to their marginal physical product (which strongly increases) divided by the interest rate (which declines).
Growth Scenario II
Our second growth scenario is characterised by a simultaneous increase of the gross savings rate and of the demand for present goods. These changes have no systematic impact on the PRI, and thus there is no relative change of spending on that account. However, the gross savings rate is substantially higher in the new structure, which is therefore much more physically productive on that account. Moreover, the new structure is much lengthier, because with a PRI that is by and large unchanging, the greater volume of savings can only be invested upstream. Thus there are two growth mechanisms at work, and the third growth mechanism is neutral. We estimate that this is the 2nd most growth-friendly variation of the time market and the production structure.
As far as monetary revenues are concerned, the general tendency is for them to fall, again because the growth deflation. What we have said in Scenario I concerning the monetary income of the owners of original factors of production applies in the present scenario by and large as well. (The only difference concerns the fact that in Scenario II spending drops in all stages, except for the new stages that are being created upstream.) One would have to expect that wages and rents remain stable or diminish slightly. By contrast, the monetary income of savers-investors will significantly increase, because the PRI does not change whereas the volume of savings strongly increases.
Real revenues will strongly increase in the aggregate. For savers-investors this implies that their real revenues will strongly increase. The owners of original factors, too, will experience a significant increase of their real incomes, for the same reasons we have spelled out in discussing Scenario I.
The present scenario is only slightly behind the first one in its positive implications for growth. (We have to keep in mind that it involves a much stronger increase of the gross savings rate than in Scenario I.) The main difference between the first two scenarios concerns their impact on the distribution of revenues. Scenario I is more favourable for income derived from original-factor ownership than for income derived from saving-investment – though both types of income increase in real terms – whereas in the present scenario it is the other way round.
Growth Scenario III
Our third growth scenario is a variant of the first one. Like the latter, it is characterised by an increase of the gross savings rate at a constant demand for present goods, and by a drop of the PRI. However, this time there occurs no lengthening of the structure of production, because the drop of the PRI overcompensates the increase of the gross savings rate. … Consider again our above numerical example. Compare the initial spending stream (Table 2) with the spending stream that we considered as a counterexample (Table 4):
159―138―120―104―90
158―154―151―148Figure 25 gives a graphical illustration of the corresponding changes on the time market and within the production structure.
[…] The old structure is lengthier, and on that account it is more physically productive than the new one. However, in the new one, spending in the second and third stages (as compared to the consumer-goods stage) is relatively higher than in the first structure. In this case too, therefore, more activity will be shifted from the consumer-good industries to stages of production upstream, and on that account, the new structure is more physically productive than the first one. Finally, the gross savings rate is marginally higher in the new structure, which is therefore more physically productive on that account too. We estimate that this is the 3rd most growth-friendly variation of the time market and the production structure.
The impact of this scenario on the distribution of monetary and real revenues is analogous to the first one. The level of monetary revenues will tend to be higher than in Scenario I because growth is less intense and there is therefore less pressure on prices. However, because the tendency for the economy to grow is less clear-cut than in the first scenario, the level of real revenues will also tend to be less elevated. […]
The most striking feature of the present scenario is its similarity to the first one. In both case, the initial causal change is an increase of the supply of present goods (savings) on the time market. But depending on the demand for present goods (the “price-elasticity” of demand), the repercussions on the time structure of production and the impact on growth are very different. The bottom-line is that a plummeting PRI, when resulting from an inelastic demand for savings, does not necessarily make for vigorous growth.
Growth Scenario IV
We have just seen that one and the same initial change of inter-temporal values, reflected in an increase of savings at a constant demand for savings, can give rise to two very different growth scenarios. Similarly, the following growth scenario is one out of two that spring from the same initial change, namely from an increase of the demand for present goods at a constant supply of present goods. On the time market, this implies a new final equilibrium at a higher PRI and a higher gross savings rate. The structure of production lengthens, but at the same time it thins out at the higher stages, with the only exception of the new stages that are being created upstream (Figure 26).
The new structure becomes increasingly thinner toward the upstream, except for the very highest stages, and on that account is less physically productive than the [old] one. However, the new structure is also lengthier and on that account more physically productive than the old one. Last but not least, the gross savings rate is higher in the new structure, which is therefore more physically productive on that account too. We estimate that this variation of the time market and the production structure is on a par with Scenario III and falls therefore within the 3rd highest growth rank. As in Scenario III, there are here two growth mechanisms at work: the lengthening of the structure of production, and the increase of the gross savings rate; and as in Scenario III, one of the growth mechanisms is deteriorating.
The striking difference between the present scenario and Scenario II is that, in the latter case, the PRI drops, whereas here it increases. However, we hold that this difference has a systematic impact, not on growth, but on distribution only.
As far as monetary revenues are concerned, the general tendency is for them to fall because the growth deflation. The monetary income of the owners of original factors of production will have a clear tendency to fall (a) because spending drops in all stages, except for the new stages that are being created upstream; and (b) because a rising PRI means that the marginal value product of the original factors will be discounted more than before. By distinct contrast, the monetary income of savers-investors will significantly increase, because both the PRI and the volume of savings strongly increase. Scenario IV therefore implies a significant reshuffling of the relative weight of income sources. Income from factor ownership will significantly decrease relative to income from saving-investment.
Real revenues will increase in the aggregate. For savers-investors this implies that their real revenues will very strongly increase. For the owners of original factors, the situation is more ambiguous because the increase of interest rates implies a stronger discount of their marginal physical product, which could completely offset the expected increase of that marginal physical product.
The present scenario is ranked on the same level of growth friendliness as Scenario III. The essential difference between these two scenarios concerns their impact on the relative weight of income types. Scenario III is more favourable for income derived from original-factor ownership than for income derived from saving-investment, whereas in the present scenario it is the other way round.
Growth Scenario V
The third growth scenario is characterised by a decrease of the supply schedule and a simultaneous increase of the demand schedule on the time market.
These changes have no systematic impact on the gross savings rate. The PRI is substantially higher in the new structure, which implies a lengthening of the structure of production. The latter therefore becomes more physically productive on that account. However, the same circumstance also exercises an adverse effect, as relative spending diminishes toward the upstream, with the only exception of the new stages. In Scenario V, only the lengthening of the structure of production is here favourable for growth, whereas the gross savings rate stays put, and the relative spending (except for the new stages upstream) deteriorates as far as the prospects for growth are concerned. We rank this scenario below all other scenarios that we have so far considered (4th rank). Indeed, it has no systematic tendency to entail economic growth. It will have this consequence only accidentally, namely, if the advantage of the lengthening more than offsets the disadvantage of the deteriorating relative spending.
As far as monetary revenues are concerned, the general tendency is for them to remain stable, because of the lacking growth dynamics (no growth deflation) and because consumer spending remains stable too. However, the strong rise of the PRI will have a significant impact on the relative weight of the different income classes. The monetary income of the owners of original factors of production will fall because a rising PRI means that the marginal value product of the original factors will be discounted more than before. By distinct contrast, the monetary income of savers-investors will increase, because the PRI [increases] while the volume of savings stays put.
Real revenues will by and large remain stable in the aggregate. The real income of savers-investors will increase. The income from original factor ownership will diminish, because the increase of interest rates implies a stronger discount of their marginal physical product, while there is no significant increase – if any – of the marginal physical product itself.
Growth Scenario VI
The sixth scenario is the exact opposite of Scenario V. It is characterised by an increase of the supply schedule and a simultaneous decrease of the demand schedule on the time market. Thus we can illustrate it with the above Figure 27, which only needs to be read backwards, with the red demand and supply schedules representing the initial situation, and the dark schedules representing the new final equilibrium.
As in Scenario V, the changes we are considering now have no systematic impact on the gross savings rate. The PRI is now substantially lower in the new structure, implying a shortening of the structure of production, which therefore becomes less physically productive on that account. However, the drop of the PRI also tends to promote relative spending upstream, with the exception of the stages that disappear. In Scenario VI, only the reshuffling of relative spending toward the upstream (except for the stages that disappear) is favourable for growth, whereas the gross savings rate stays put, and the structure of production shortens. It therefore has no systematic tendency to entail economic growth. We therefore rank it in category 4.
The impact of Scenario VI on monetary and real revenues is exactly analogous to the one of Scenario V. Thus its distributional consequences are the exact inverse of those that we found in that former scenario. […]
Growth Scenario VII
Scenario VII is the exact opposite of the above Scenario IV. It is characterised by a decrease of the demand for present goods at a constant supply of present goods. On the time market, this implies a new final equilibrium at a lower PRI and a lower gross savings rate. The structure of production shortens, but at the same time it becomes wider in the higher stages, with the exception of the stages that disappear. We can illustrate Scenario VII with the above Figure 26, which only needs to be read backwards, with the red demand and supply schedules representing the initial situation, and the dark schedules representing the new final equilibrium.
As the new structure becomes increasingly wider toward the upstream, except for the highest stages, it is on that account more physically productive than the new old. However, the new structure is also shorter and its gross savings rate is lower. Thus, Scenario VII features only one basic mechanism promoting growth, whereas the other two basic mechanisms entail the opposite tendency. It therefore seems to be barely justified to speak of a “growth” scenario at all. However, we cannot exclude on purely theoretical grounds that the one positive mechanism overcompensates the two others. This has to be determined empirically for each individual setting. In any case, this is the least probable of all growth scenarios that we have considered. We therefore rank it in a 5th category.
The impact of Scenario VII on monetary and real revenues is exactly analogous to the one of Scenario IV. Thus its distributional consequences are the exact inverse of those that we found in that former scenario. […]
Growth Scenario VIII
Our last scenario is the exact opposite of the above Scenario III. It is characterised by a decrease of the supply of present goods at a constant and inelastic demand schedule, resulting in a lengthening of the structure of production. On the time market, this implies a new final equilibrium at a higher PRI and a lower gross savings rate. The structure of production lengthens, but at the same time it becomes thinner in the higher stages, with the exception of the new stages. We can illustrate Scenario VIII with the above Figure 25, which needs to be read backwards, with the red demand and supply schedules representing the initial situation, and the dark schedules representing the new final equilibrium.
Just as in the preceding case of Scenario VII, the present growth scenario features only one basic mechanism promoting growth, whereas the other two basic mechanisms entail the opposite tendency. We therefore rank it in the same 5th category in which we have classed Scenario VII.
The impact of Scenario VII on monetary and real revenues is exactly analogous to the one of Scenario III. Thus its distributional consequences are the exact inverse of those that we found in that former scenario. […]
We shall now turn to consider two complications, by dropping previous assumptions, namely (1) the assumption that the economy operates without consumer credit and (2) the assumption that monetary conditions remain stable.
As can be seen, the distinction between the widening of the structure of production (SoP) and the lenghtening is of crucial importance As discussed in the section “Capital-Based Growth: Basic Mechanisms” a widening of the SoP without a lenghtening of the SoP has the same effect as a widening of the SoP combined with a lenghtening of the SoP. I highly recommend to read the paper (starting from page 13). I hope someone would try to discuss the topic. Because this issue is often ignored by the austrians, as Hülsmann pointed out :
One, there was without any doubt a certain intellectual laziness. The basic “universal” relation between time preference and the investment horizon intuitively makes sense and finds, within the context of a monetary economy, a ready confirmation in the standard savings-based growth scenario that more or less monopolised the attention of Austrian economists. As a consequence, until very recently nobody had a closer critical look.
I also recommend this two papers, by Renaud Fillieule.
The “Values-Riches” Model: An Alternative To Garrison’s Model in Austrian Macroeconomics of Growth and Cycle
A Formal Model in Hayekian Macroeconomics: The Proportional Goods-in-Process Structure of Production