Austrian Capital Theory A Prelude to Capital-Based Macroeconomics

The Hayekian Stages-of-Production ModelThe Knightian Stock-Flow Model

July 21, 2014

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The Keynesian “Animal Spirits” Model

“Capital Structure”: The Temporal Pattern of Heterogeneous Capital Goods

“Capital Stock”: The Stock of ProductiveFactors that Yield a Flow ofConsumption 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”

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.

The Measuring of “Structured Capital”

(units)

(units)

(units)

units

worker-hours

acres

doseschunkshunks

Not all ____________ of land are alike.

Not all ____________ of labor are alike.

Not all ____________ of capital are alike.

dosechunkhunk

Knight and Hayek Butted Heads about Capital

Frank H. Knight 1885 — 1972

Friedrich A. Hayek1899 — 1992

Clark and Bohm-Bawerk Butted Heads about Capital

John Bates Clark 1847 — 1938

Eugen von Bohm Bawerk 1851 — 1914

Black-Box Capital Theory (Clark and Knight)

THECAPITALSTOCK

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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.”

FLOW OF CONSUMPTION

MAINTENANCE OF CAPITAL

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THECAPITALSTOCK

A STEADY-STATE ECONOMYA 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.”

Black-Box Capital Theory (Clark and Knight)

The Capital Stock is permanent, in a sense.

MAINTENANCE OF CAPITAL

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THECAPITALSTOCK

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.

A STEADY-STATE ECONOMY

The “permanent” Capital Stock yields a “perpetual” flow.

QUALIFICATIONS: “in a sense,” “as it were,” “so to speak,”….

Black-Box Capital Theory (Clark and Knight)

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THECAPITALSTOCK

We have a system of “sources” yielding “services.”

SOURCES

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.

We have a system of “capital” yielding “consumable output.”

FLOW OF CONSUMPTION

MAINTENANCE OF CAPITAL

SERVICES

SOURCES

Black-Box Capital Theory (Clark and Knight)

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Black-Box Capital Theory (Clark and Knight)

AN EXPANDING ECONOMY

THECAPITALSTOCK

THECAPITALSTOCK

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Black-Box Capital Theory (Clark and Knight)

THECAPITALSTOCK

A CONTRACTING ECONOMY

Black-Box Capital Theory (Clark and Knight)

Once a Steady State is reached, production time is “irrelevant.”

Each period, a sapling is set out, and a mature tree is harvested.

It is the setting out that “enables” the harvesting.

Setting out the sapling (now) “produces” the harvestable tree (now).

Production and consumption are “simultaneous.”

What about production time in a Clark-Knight vision?

YEAR 1YEAR 2

QUALIFICATIONS: “in a sense,” “as it were,” “so to speak,”….

The trees have a linear maturity structure (log-linear, actually).

George Stigler defends Clark and dismisses Bohm-Bawerk on the basis of the simultaneity of production and consumption:

“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

The next period presents us with the same maturity profile.

Knight and Hayek Butted Heads about Capital

Maintenance is a “technical” detail.

Maintenance is a matter of choice.

Capital is “permanent.”

Capital depreciates but is augmentable.

Capital is the “only” factor.

Capital is heterogeneous but multi-specific.

Production time is “irrelevant”

Production time is a key variable.

It’s all about “sources” and “services.”

It’s all about temporal capital structure.

It’s about “stocks” and “flows.”

It’s about dynamic market processes.

KN

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GOODS OF THE FIRST ORDER

GOODS OF THE SECOND ORDER

GOODS OF THE THIRD ORDER

GOODS OF THE FOURTH ORDER

GOODS OF THE FIFTH ORDER

GOODS OF THE SIXTH ORDER

GOODS OF THE SEVENTH ORDER

MENGER’S LAW

Production P

roceeds Top to B

ottom

Val

ue I

mpu

tatio

n go

es f

rom

Bot

tom

to

Top

H I

G H

E R

O

R D

E R

G

O O

D S

CONSUMPTION GOODS

The value of higher order goods derives from the value of the respective consumer goods.

Bohm-Bawerk’s Maturity Classes

RICH COUNTRY

POOR COUNTRY

GOODS OF THE FIRST ORDER

GOODS OF THE SECOND ORDER

GOODS OF THE THIRD ORDER

GOODS OF THE FOURTH ORDER

GOODS OF THE FIFTH ORDER

GOODS OF THE SIXTH ORDER

GOODS OF THE SEVENTH ORDER

O R

D E

R S

O F

G O

O D

SS

T A

G E

S O

F P

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D U

C T

I O N

The Hayekian Triangle

PRODUCTION TIME (A SEQUENCE OF STAGES)

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

The temporally defined stages are arrayed graphically from left to right, the output of the final stage constituting consumable output.

Early-stage investment activity is exemplified by product development.

The Structure 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.

STAGES OF PRODUCTION

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PRODUCTDEVELOPMENT

INVENTORYMANAGEMENT

Late-stage investment activity is exemplified by inventory management.

WE ARE HERE

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

YOU ARE HERE

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.

Watch the “goods in process,” move through the stages.

STAGES OF PRODUCTION

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The Structure of Production

The Structure 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.

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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.

Watch the Structure of Production expand.C

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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.

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STAGES OF PRODUCTION

Watch the structure of production respond to an increase in saving.

Note the emergence of a sixth stage of production.

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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.

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.

THECAPITALSTOCK

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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.

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STAGES OF PRODUCTION

THECAPITALSTOCK

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The increased output of consumer goods emerges over time as the early and intermediate products move through the more time-consuming structure of production.

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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.

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.

STAGES OF PRODUCTION

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THECAPITALSTOCK

LET’S DO OPEN

Knight and Hayek Butted Heads about Capital

Frank H. Knight 1885 — 1972

Friedrich A. Hayek1899 — 1992

Austrian Capital Theory A Prelude to Capital-Based Macroeconomics

The Hayekian Stages-of-Production ModelThe Knightian Stock-Flow Model

July 21, 2014

Two Views: