Austrian Capital Theory A Prelude to Capital-Based Macroeconomics

1. Austrian Capital Theory A Prelude to Capital-Based Macroeconomics Two Views: The Hayekian Stages-of-Production Model The Knightian Stock-Flow Model The Keynesian “Animal Spirits” Model July 21, 2014

2. “Capital Structure”: The Temporal Pattern of Heterogeneous Capital Goods “Capital Stock”: The Stock of Productive Factors that Yield a Flow of Consumption Goods “Human Capital’: Present Value of a (Skilled) Worker’s Future Earnings “Capitalized Value” Present Value of (net) Future Receipts “Working Capital”: Goods in Process---Raw Materials & Semi-finished goods “Fixed Capital”: Plant and Equipment (Fixed implies Durable) “Financial Capital”: Cash and Funds Raised by e.g. Stock and Bond sales “Bank Capital”: Assets minus Liabilities, i.e., Net Worth. The Many Meanings of “Capital”

3. The Measuring of “Structured Capital” Capital is heterogeneous. But aren’t labor and land heterogeneous, too? Capital is radically heterogeneous. Well, just how radical is capital heterogeniety? Capital is dimensionally heterogeneous.

4. The Measuring of “Structured Capital” (units) Not all ____________ of labor are alike. worker-hours (units) acres Not all ____________ of land are alike. doses chunks (units) hunks Not all ____________ of capital are alike. hunk units dose chunk

5. Clark and Bohm-Bawerk Butted Heads about Capital Knight and Hayek Butted Heads about Capital Frank H. Knight 1885 — 1972 John Bates Clark 1847 — 1938 Eugen von Bohm Bawerk 1851 — 1914 Friedrich A. Hayek 1899 — 1992

6. Black-Box Capital Theory (Clark and Knight) A flight recorder on an aircraft. Any complex piece of equipment, typically a “plug-and-play” unit in an electronic system, with contents about which the user has “no need to know.” THE CAPITAL STOCK DO NOT OPEN

7. Black-Box Capital Theory (Clark and Knight) A STEADY-STATE ECONOMY A flight recorder on an aircraft. Any complex piece of equipment, typically a “plug-and-play” unit in an electronic system, with contents about which the user has “no need to know.” MAINTENANCE OF CAPITAL THE CAPITAL STOCK FLOW OF CONSUMPTION DO NOT OPEN

8. Black-Box Capital Theory (Clark and Knight) A STEADY-STATE ECONOMY The Capital Stock includes maintenance as a “technical" detail. Hence, the Capital Stock is “permanent.” The Capital Stock is permanent, as it were. The Capital Stock is permanent, so to speak. The Capital Stock is permanent, in a sense. MAINTENANCE OF CAPITAL THE CAPITAL STOCK DO NOT OPEN The “permanent” Capital Stock yields a “perpetual” flow. QUALIFICATIONS: “in a sense,” “as it were,” “so to speak,”….

9. Black-Box Capital Theory (Clark and Knight) We have a system of “sources” yielding “services.” We have a system of “capital” yielding “consumable output.” There is only one factor of production. It’s “capital” ---in the broad sense of “sources.” Land, labor, and capital are all “capital” in the broad sense. MAINTENANCE OF CAPITAL SOURCES THE CAPITAL STOCK SOURCES SERVICES FLOW OF CONSUMPTION DO NOT OPEN

10. Black-Box Capital Theory (Clark and Knight) THE CAPITAL STOCK DO NOT OPEN

11. Black-Box Capital Theory (Clark and Knight) AN EXPANDING ECONOMY THE CAPITAL STOCK THE CAPITAL STOCK DO NOT OPEN

12. Black-Box Capital Theory (Clark and Knight) A CONTRACTING ECONOMY THE CAPITAL STOCK

13. What about production time in a Clark-Knight vision? George Stigler defends Clark and dismisses Bohm-Bawerk on the basis of the simultaneity of production and consumption: YEAR 1 YEAR 2 “We can say that any one row [of trees] takes fifty years to mature, but since there is a constant output of timber forever, there is simply no point in saying it.” George Stigler, Production and Distribution Theories, 1941 Once a Steady State is reached, production time is “irrelevant.” The trees have a linear maturity structure (log-linear, actually). Each period, a sapling is set out, and a mature tree is harvested. The next period presents us with the same maturity profile. It is the setting out that “enables” the harvesting. Setting out the sapling (now) “produces” the harvestable tree (now). Production and consumption are “simultaneous.” QUALIFICATIONS: “in a sense,” “as it were,” “so to speak,”….

14. Knight and Hayek Butted Heads about Capital Maintenance is a “technical” detail. KNIGHT Capital is “permanent.” Capital is the “only” factor. Production time is “irrelevant” It’s all about “sources” and “services.” It’s about “stocks” and “flows.” Maintenance is a matter of choice. Capital depreciates but is augmentable. HAYEK Capital is heterogeneous but multi-specific. Production time is a key variable. It’s all about temporal capital structure. It’s about dynamic market processes.

15. Bohm-Bawerk’s Maturity Classes MENGER’S LAW The value of higher order goods derives from the value of the respective consumer goods. GOODS OF THE SEVENTH ORDER GOODS OF THE SIXTH ORDER RICH COUNTRY GOODS OF THE FIFTH ORDER Production Proceeds Top to Bottom H I G H E R O R D E R G O O D S GOODS OF THE FOURTH ORDER Value Imputation goes from Bottom to Top GOODS OF THE THIRD ORDER GOODS OF THE SECOND ORDER POOR COUNTRY GOODS OF THE FIRST ORDER CONSUMPTION GOODS

16. GOODS OF THE SEVENTH ORDER GOODS OF THE SIXTH ORDER GOODS OF THE FIFTH ORDER S T A G E S O F P R O D U C T I O N GOODS OF THE FOURTH ORDER O R D E R S O F G O O D S GOODS OF THE THIRD ORDER GOODS OF THE SECOND ORDER GOODS OF THE FIRST ORDER

17. The Hayekian Triangle PRODUCTION TIME (A SEQUENCE OF STAGES)

18. ---from F. A. Hayek’s 1941, The Pure Theory of Capital

19. The Structure of Production CONSUMPTION STAGES OF PRODUCTION Capital-based macroeconomics disaggregates capital intertemporally. Consumable output is produced by a sequence of stages of production, the output of one stage feeding in as input to the next. Early-stage investment activity is exemplified by product development. Late-stage investment activity is exemplified by inventory management. The temporally defined stages are arrayed graphically from left to right, the output of the final stage constituting consumable output. PRODUCT DEVELOPMENT INVENTORY MANAGEMENT

20. WE ARE HERE YOU ARE HERE The directory at the front gate includes the conventional YOU ARE HERE sign but no Hayekian WE ARE HERE sign.

21. The Structure of Production CONSUMPTION Watch the “goods in process,” move through the stages. STAGES OF PRODUCTION For pedagogical convenience, the initial capital structure is shown as having five stages. With growth, the number of stages will increase. Although all five of these stages are in operation during each time period, resources can be tracked through the structure of production over time.

22. The Structure of Production CONSUMPTION STAGES OF PRODUCTION NOTE: Hayek introduced his triangle in 1931, when Henry Ford was still producing the Model A. If only Hayek had had PowerPoint, he could have shown how the abstract triangle aligns with real-world output.

23. CONSUMPTION Watch the Structure of Production expand. STAGES OF PRODUCTION Together, the sequence of stages form a Hayekian triangle, a summary depiction of the economy’s intertemporal structure of production. In an economy experiencing secular growth, the triangle increases in size but not (or not necessarily) in shape.

24. CONSUMPTION STAGES OF PRODUCTION When people choose to save more, the change in their preferred temporal pattern of consumption is registered by the market, first and foremost by a reduction in interest rates. Reduced current consumption frees up resources in the late stages---which can then be employed in the early stages. Lower interest rates favor more time-consuming production processes.

25. Watch the structure of production respond to an increase in saving. CONSUMPTION Note the emergence of a sixth stage of production. STAGES OF PRODUCTION When people choose to save more, the change in their preferred temporal pattern of consumption is registered by the market, first and foremost by a reduction in interest rates. Reduced current consumption frees up resources in the late stages---which can then be employed in the early stages. Lower interest rates favor more time-consuming production processes.

26. THE CAPITAL STOCK CONSUMPTION DO NOT OPEN STAGES OF PRODUCTION In the Hayekian theory, increased saving results in a reallocation of resources towards the early stages of production. Here, the differential interest-rate sensitivities are at work. In the Knightian theory, increasing saving beyond capital-maintenance requirement results in a an increase in the capital stock but with no implications about capital’s temporal structure.

27. THE CAPITAL STOCK CONSUMPTION DO NOT OPEN STAGES OF PRODUCTION In the Knightian theory, increasing saving beyond capital-maintenance requirement results in a an increase in the capital stock but with no implications about capital’s temporal structure. The increased output of consumer goods emerges over time as the early and intermediate products move through the more time-consuming structure of production.

28. THE CAPITAL STOCK CONSUMPTION LET’S DO OPEN STAGES OF PRODUCTION We can clearly see the critical difference between Knight and Hayek. If we burn through the casing of the Knightian Black Box, we see the Hayekian temporal structure of capital that allows for differential interest-rate sensitivity and hence reveals the market mechanism that tailors production plans to intertemporal preferences. If interest rates are telling the truth about people’s willingness to save, we get genuine, sustainable growth. If interest rates are being held down by the central bank we get an artificial boom followed by a bust.

29. Knight and Hayek Butted Heads about Capital Frank H. Knight 1885 — 1972 Friedrich A. Hayek 1899 — 1992

30. Austrian Capital Theory A Prelude to Capital-Based Macroeconomics Two Views: The Hayekian Stages-of-Production Model The Knightian Stock-Flow Model July 21, 2014